Strong jobs, falling bonds

Non-farm payrolls rose by 336,000 in September, nearly double the consensus forecast. The bond market did not celebrate. Traders sold government bonds hard and all at once, because fixed-income desks now treat unusually strong growth as a threat while inflation stays high.

What the report showed

The headline was not the only surprise. Payroll gains for July and August were revised up by more than 100,000 between them, so the labour market has been stronger all summer than the first estimates suggested. The unemployment rate held at 3.8 per cent. Hiring was broad, with leisure and hospitality, government and health care all adding jobs, which makes it hard to dismiss the number as a quirk of one sector or of seasonal adjustment.

The softer detail was pay. Average hourly earnings rose by 0.2 per cent on the month and by 4.2 per cent on the year, the slowest annual pace since mid-2021. That is the one piece of the report that doves could cling to, because it suggests the extra workers are being found without a bidding war that would feed straight into service-sector prices.

Strong hiring, higher yields

The payroll figure demolished what was left of the case that the US economy was about to slip into a cyclical slowdown. Demand for workers is still enormous, and traders repriced real yields across the curve. Higher real yields tighten financial conditions and push down equity valuation multiples. They also make the government's interest bill steadily more painful.

The move came on top of a sell-off that was already under way. The ten-year Treasury yield had been climbing since the summer and touched its highest level since 2007 after the report. Since the Federal Reserve kept its target range at 5.25 to 5.50 per cent in September and pencilled in fewer cuts for next year, a strong payroll print tells investors that the committee has no reason to relent, and possibly a reason to raise rates once more.

Why good news hurts

The mechanism runs through the real rate. A bond yield can be split into expected inflation and the real return investors demand on top. When growth surprises on the upside while inflation is still above the Fed's 2 per cent target, investors conclude that policy rates will stay high for longer, and they also ask for more compensation for lending to a government running large deficits into a strong economy. Both push up the real component, which is the part that matters most for valuations and for borrowers whose income does not rise with prices.

For equities the arithmetic is simple. A stock is worth its future profits discounted at a rate that includes the real yield, so a higher real yield lowers the value of distant earnings most. Companies whose profits lie far in the future, such as unprofitable technology firms, suffer more than utilities or banks whose cash comes sooner. Strong hiring does raise expected earnings, but in this report the discount-rate effect dominated at the open.

Housing feels the move first. The average thirty-year mortgage rate is at its highest in more than two decades, and each rise in the ten-year yield passes through to new loans within days. Existing owners locked into cheap fixed-rate mortgages are reluctant to sell, so the squeeze falls hardest on first-time buyers and on housebuilders' order books.

A lesson from 1994

The closest precedent is 1994, when a strong economy and a Fed that kept raising rates produced one of the worst years on record for bonds. Investors had borrowed heavily to bet that yields would stay low. Orange County in California lost so much on leveraged bond positions that it filed for bankruptcy in December of that year, and the Mexican peso collapsed in the same month. The lesson is that rising yields do their damage at the most heavily geared points of the system, and usually with a lag of months.

Today the obvious candidates are different but the pattern is familiar. Commercial property owners who financed buildings at low floating rates face refinancing at far higher ones. Companies owned by private-equity firms, many carrying leveraged loans that reset with short-term rates, are paying interest bills they did not plan for. Regional banks with large holdings of underwater bonds, the weakness that sank Silicon Valley Bank in March, see those losses grow with every rise in yields.

The case for calm

The counterargument deserves a hearing. Wage growth is slowing, inflation has fallen by more than half from its peak last year, and a larger workforce can produce more without overheating. If the strong hiring reflects immigration and higher participation rather than excess demand, the Fed may conclude that it can hold rates steady and let time do the work. The rise in long-term yields itself tightens financial conditions, which some Fed officials may treat as a substitute for another increase.

That argument may prove right, but it does not help borrowers in the meantime. Whether the Fed hikes again or simply holds, real yields high enough to strain leveraged balance sheets are the price of an economy that refuses to slow. The data that will settle the question are the September consumer-price figures due next week, the October payroll report and the Fed's meeting at the start of November.

While inflation stays high, every strong jobs report will push real yields up, and the most heavily indebted borrowers will be the first to crack. Floating-rate commercial landlords and private-equity-owned companies are the likeliest to show strain, through defaults and distressed refinancings, over the next twelve months.