Softening Labor Market Tees Up Interest Rate Cuts, Ignites Bond Rally

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

There’s no crystal ball when it comes to predicting the Federal Reserve’s next move. Yet financial markets are currently pricing in a 100 percent chance that the U.S. central bank will slash interest rates at its next meeting on September 17. The reason for such definitiveness? A fresh batch of notably weak jobs data, leading investors to double down on bets that the Fed could lower its benchmark by as much as 50 basis points.

The latest nonfarm payroll report from the Bureau of Labor Statistics (BLS), which we’ll detail later in the commentary, showed hiring in August came in well below Wall Street estimates, marking a slowdown from July’s 79,000 increase, which was revised up by 6,000. Meanwhile, the unemployment rate rose to 4.3 percent.

The data also provided clues to another big question on investors’ minds: Will President Donald Trump’s sweeping levies against key U.S. trading partners cause rising inflation, slowing growth and a cooling labor market, or both? The latest insights reaffirmed what we and Federal Reserve Chair Jerome Powell have been forecasting for weeks now: “The balance of risks appears to be shifting” toward the labor market, to quote Powell at last month’s Jackson Hole Economic Symposium. While lingering inflation remains a major concern, a softening jobs market may be the most pressing risk when it comes to the long-term impacts of tariffs as the Fed teeters between its dual mandate of stable prices and maximum employment.

Judging by Wall Street’s reaction to the latest jobs data, the U.S. central bank’s balancing act may already be in jeopardy. Stocks retreated on Friday amid fears that the Fed is falling behind in its mission to prevent jobs weakening at a time when inflation is exhibiting signs of increasing stickiness. The S&P 500 shaved off 0.3 percent, and the Dow Jones Industrial Average fell 0.5 percent, while the tech-heavy Nasdaq 100 remained little changed. The employment jitters meanwhile ignited a rally in Treasurys, sending the 10-year yield down seven basis points to 4.07 percent and the two-year yield down six basis points to 3.51percent, nearing its lowest level since 2022.

All signs point to lower interest rates on the horizon as the Fed looks to counter the cooling jobs market—which could weigh on company earnings in the near term but with potentially lower borrowing costs in the future that could create a more favorable environment for broad equity markets in the intermediate term. We note that since the first weak jobs report on August 1, interest rate-sensitive U.S. Small and Mid Caps have outperformed their Large-Cap peers as the 10-year Treasury has fallen from 4.37 percent to 4.07 percent to end this week. However, history shows us that Fed rate cuts aren’t always the immediate magical cure for labor market weakness that some investors might hope. The U.S. central bank has opted to cut rates ahead of the last four economic contractions on record. Low consumer and business confidence, inflation concerns, economic uncertainty, and even technological changes—such as the rise of generative and agentic artificial intelligence—are all factors that can weigh on the labor market.

As we said before, there is no way to see directly into the future—especially in a market that has been subject to unpredictable swings with each new tariff announcement, trade spat or global conflict. Instead, we remain focused on diversification to prepare for all possibilities, wherever the economy takes us next.

Let’s dive further into this week’s data.

Wall Street Wrap

The slowing labor market, by the numbers: Starting off with the August nonfarm payrolls report, nonfarm payrolls increased by just 22,000, a far cry from Wall Street’s expectations of 75,000. This reflected a significant slowdown from July’s 79,000 increase, which was revised up by 6,000. Contributing to the worsening jobs picture, the report also showed a net loss of 13,000 in June after May’s estimate was revised down to 19,000 jobs being added. This places the last four months at an average of 27,000 jobs added.

Health care once again led job growth, adding 31,000 new positions, while social assistance added 16,000. Over the past four months these two noncyclical segments are responsible for the entirety of the labor market gains (and more) with an average of 62,000 jobs added. This narrow labor market is reflected in the diffusion index (percentage of industries hiring) being less than 50 percent for the past four months. Despite the slowdown in hiring, average hourly earnings increased 0.3 percent for the month, meeting estimates. A hiring slowdown was also apparent in the private sector, according to ADP’s latest National Employment Report, averaging 54,000 jobs in August and failing to meet the +68,000 consensus.

The BLS’s other jobs report, the more volatile household survey, reflected 288,000 new hires in August, while the number of workers in the labor market rose by 436,000, a ratio that pushed up the unemployment rate from 4.2 percent to 4.3 percent, a level not seen since September 2017 aside from the COVID-19 pandemic. Despite these additions in August, this report has shown a similar weakness over the past four months, with 575,00 job losses.

Manufacturing continues to shrink: The latest manufacturing data from the Institute for Supply Management (ISM) showed a reading of 48.7 (readings below 50 signal contraction). While this marks the sixth consecutive month in contraction territory, the contraction moved at a slower rate than last month’s 48 percent.

Readings for new orders came in at 51.4 percent, 4.3 points higher than July’s 47.1 and thus marking an expansion after six consecutive months of contraction. The production index fell 3.6 points to 47.8 percent, signaling a contraction.

“In August, U.S. manufacturing activity contracted at a slightly slower rate, with new orders growth the biggest factor in the 0.7 percentage point gain of the Manufacturing PMI. However, since production contracted at a rate nearly equal to the expansion in new orders, the Manufacturing PMI increase was nominal,” Susan Spence, chair of the Institute for Supply Management Manufacturing Business Survey Committee, said in comments released with the report.

Input costs rose (albeit at a slower pace), with the latest reading of the price index coming in at 63.7. In total, 15 of the 18 industries in the survey reported paying higher prices, and none reported decreased costs.

Slowing demand and higher costs continue to weigh on payrolls, with the latest reading of the employment index of 43.8 percent in August marking a 0.4 percentage point increase from July’s reading of 43.4 percent. The marker remains in contraction territory despite this slight uptick. None of the six largest industries reported adding staff, and of the 18 total manufacturing industries covered by the report, just two noted hiring. These results are consistent with the hard data in the BLS’s nonfarm payrolls report.

Services continue a modest expansion: The ISM Services Purchasing Managers’ Index (PMI)rose from 50.1 to 52.0 in August, the highest level observed since February, suggesting a modest rebound in services activity after a contraction in July. (Readings above 50 are consistent with expansion; readings below 50 indicate contraction.) Economists had forecast an increase to 51.0. The report’s employment index remained in contraction, rising slightly from 46.4 to 46.5. When combined with August’s ISM Manufacturing Index, these releases paint a mixed economic picture of ongoing manufacturing weakness alongside modest services sector growth against a backdrop of labor market softening and lingering price pressures.

The Fed’s Beige Book flags tariff impacts across industries: The Federal Reserve’s latest "Beige Book" report further underscored the issues of stubborn inflation and a slowing labor force. Overall, eight of the 12 districts reported little or no change since July, with four reporting modest growth. Across districts, consumer spending was reported as flat to declining because wages are failing to keep up with rising prices.

Reflecting a weakening (low hiring but also low firing) labor market, 11 districts reported little or no net change to overall employment with one district reporting a modest decline. Seven districts noted firms were hesitant to hire due to uncertainty and/or weaker demand. Multiple districts reported reducing headcount through attrition, while two districts reported layoffs. Wage growth was generally reported as modest to moderate, with two districts reporting little or no change in wages. Of the 12 districts surveyed in the report, 10 characterized price growth as moderate or modest, while two districts described strong input price growth. Tariff-related price increases were noted across all districts, particularly impacting input prices. Most districts reported that firms were expecting price increases to continue in the months ahead, with three of those districts noting that the pace of price increases was expected to rise further.

This report highlights the delicate balance the Fed is attempting to walk as both sides of their dual mandate of full employment and stable prices appear at risk.

The week ahead

Tuesday: The BLS will release data for the first quarter of 2025 from its Quarterly Census of Employment and Wages (QCEW) at 10am EST. It will also publish preliminary benchmark revisions for March 2025 for all 50 states, the District of Columbia and selected metropolitan areas at the total nonfarm level. This will provide further insight on wages and employment in the U.S. as we continue to develop a broader understanding of tariff impacts across America.

Separately, the National Federation of Independent Business (NFIB) will release its monthly findings on the NFIB Small Business Optimism Index. Small business optimism has ticked higher recently, albeit with signs of labor market weakness and price pressures. The index rose 1.7 points in July to 100.3, slightly above the 52-year average of 98, as respondents reported improved business conditions and an openness toward expansion. We’ll be monitoring this for further information on the state of the more cyclical small business segment of the U.S. economy.

Wednesday: The BLS will release August data from its Producer Price Index for final demand at 8:30am EST. The Producer Price Index rose 0.9 percent in July. Prices for final demand services advanced 1.1 percent, and the index for final demand goods increased 0.7 percent. On an unadjusted basis, the index for final demand moved up 3.3 percent for the 12 months ended in July.

Thursday: The BLS will release the Consumer Price Index (CPI) for August 2025, the final inflation report to be released ahead of the Fed’s September meeting, at 8:30am EST. Price pressures have recently begun to rise as companies are passing along increased costs. Given the recent labor market weakness, investors and the Fed will be looking to the report for evidence that inflation is not accelerating.

Friday: The University of Michigan issues its preliminary report on September consumer sentiment and inflation expectations. Consumer sentiment fell in August for the first time in four months, according to last month’s survey results, indicating that consumers expected higher unemployment to follow, while inflation expectations for both the next year and five to 10 years rose after a July pullback.

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