The stock market rallied while bond yields fell sharply this week in a dramatic reversal, as fresh economic data suggested the Federal Reserve’s interest rate hikes are slowing the US economy and labor market.

The S&P 500 jumped nearly 6%, notching its best week of 2022, while the 10-year Treasury yield dropped back below 4.6% after breaching 4.2% in late October. The declines in longer-term yields, which impact borrowing costs economy-wide, came after a weaker-than-expected October jobs report on Friday.

The US added 261,000 jobs last month, down from 315,000 in September, indicating the hot labor market is cooling. The unemployment rate ticked up to 3.7% from 3.5%. This suggests the Fed’s aggressive rate hikes intended to reduce demand and curb persistent inflation are having the desired moderating effect on growth and employment.

“The October jobs data is an unambiguous positive,” said Ronald Temple, chief market strategist at Lazard. “It signals to the Fed they are successfully slowing the economy and don’t need to raise rates again.”

The Fed has hiked its benchmark rate 5 times this year from near zero to a range of 3.75% to 4%, attempting to combat inflation hovering around 40-year highs. But investors grew concerned rapidly rising longer-term Treasury yields could hurt growth and make the massive US debt load unsustainable.

Those worries eased after Fed Chair Jerome Powell said ongoing increases in longer-term rates would need to be “persistent” to alter policy. The Treasury also announced plans to reduce issuance of longer-term bonds, which put downward pressure on yields.

“This week’s drop in yields is a huge relief after the surge in September and October raised alarms about the economy’s resilience,” said BlueBay’s Mark Dowding. “But if longer-term yields keep falling, it could actually spur the Fed to hike more aggressively.”

Weaker Labor Market Reduces Pressure on Fed to Raise Rates Again

The October jobs data was a key factor in the reversal, as it suggests the Fed’s actions to slow growth are taking hold. The 261,000 jobs added was the smallest gain since December 2020. Private payrolls increased by just 209,000, down from 270,000 in September.

“Moderating job growth is evidence the Fed has been successful in engineering a soft landing,” said Dana Peterson, chief economist at The Conference Board. “This report reduces the likelihood of another 75 basis point rate hike in December.”

Financial markets are now pricing in a 50 basis point hike in December, down from 75 basis points earlier. Markets have also pulled forward expectations for when the Fed will cut rates, foreseeing potential reductions in late 2023 if economic weakness persists.

The cooling job market, while positive for controlling inflation, does show cracks emerging across sectors. Employment in housing and manufacturing declined in October, as rising rates slowed demand. Some economists warn the jump in unemployment could be an ominous sign.

“Once unemployment starts ticking higher it tends to keep rising,” cautioned T. Rowe Price’s Blerina Uruci. “So I’m watching closely to ensure the labor market slowdown remains orderly.”

Stocks Rebound on Expectations of Moderating Rate Hikes

Equities rallied strongly across indexes, with the S&P 500 vaulting 5.9% for its best week since June. The tech-heavy Nasdaq jumped 8.1% and the small-cap Russell 2000 index surged 7.9%. The rally reversed October’s losses.

The weaker jobs data boosted stocks by reducing expectations of further aggressive Fed rate increases that could severely hamper growth. Riskier assets like equities have struggled this year as rates climbed, with the S&P 500 down over 18% year-to-date despite this week’s gains.

“Stock markets cheered the potential peak in rates,” said Commonwealth Financial Network’s Chris Chen. “If the Fed downshifts to 50 basis point hikes, that’s a positive signal for investors looking for a bottom.”

Further stock gains could be ahead if bond yields continue falling, easing financial conditions. But some strategists say celebrate cautiously, as risks remain.

“Yields are still substantially above August lows,” noted David Rosenberg of Rosenberg Research. “Stocks may be getting ahead of themselves until we see a more definitive pause in rate hikes and clear signs inflation is abating.”

Is the Bond Rally Sustainable or a Dead Cat Bounce?

The yield on the 10-year Treasury note plunged from 4.15% on October 21 to below 4.2% this week, before landing around 3.7% on Friday following the jobs report. The two-year yield also declined sharply. Falling longer-term yields could help drive an economic rebound.

“Declining bond yields after a meteoric rise will boost housing and support consumer spending,” said Oxford Economics’ Nancy Vanden Houten. She projects the 10-year yield will end 2023 at 3.63%.

But analysts debate whether this bond rally has staying power. Wells Fargo’s Michael Taylor expects limited upside for Treasuries as inflation remains sticky and the Fed stays hawkish.

Some strategists argue lower yields now could actually spur more Fed tightening if it eases financial conditions prematurely before inflation is tamed.

“Don’t assume this rally in bonds means the coast is clear,” warned BlackRock’s Rick Rieder. “We could see more volatility as the market balances slower growth against still-high inflation.”

The path forward depends on incoming data on jobs, consumer spending and whether inflation continues descending from recent peaks. For now, markets are optimistic the Fed’s battle against rising prices is making progress. But as this past week demonstrated, investor sentiment can shift rapidly amid an uncertain outlook.

The Bottom Line

The shocking retreat in Treasury yields and rebound in stocks suggests investors believe evidence is mounting that tighter Fed policy is slowing growth and inflation enough to warrant a more cautious stance on interest rates going forward.

But volatility is likely to remain elevated, as markets balance incoming data on the health of the economy against the Fed’s commitment to bring inflation firmly down to its 2% target. Any renewed surge in bond yields or hints of stubborn inflation could dash hopes for a “soft landing” and send markets on another wild ride.

Despite this week’s rally, risks remain until concrete signs emerge that the Fed is prepared to stop hiking rates and perhaps begin cutting again in 2023 if the economy backslides into recession. For now, investors are advised to buckle up and get ready for more potential market swings ahead.