The Market Is Rethinking That Disastrous Jobs Report

Markets are already thinking that that bad jobs report on Friday may have been just noise, and that the economy is still doing fine.

Treasuries are falling and interests rates are rising this morning as investors sell bonds in the wake of the release of two better-than-expected economic data points: the New York Fed's Empire State Manufacturing Activity Index, and December producer prices.

The Empire State index surged to 12.51 from December's 0.98 reading, and sub-components of the index (most notably, employment) were strong across the board. Producer prices excluding food and energy rose three times faster than expected, but most of the rise was concentrated in prices of tobacco products, which were up 3.6% in December.

The yield on the 10-year Treasury note is trading at 2.90%, three basis points higher from yesterday's close. The sell-off is being led by the belly of the curve, with yields on 5-year and 7-year notes each up 4 basis points.

Normally the Empire State index and producer prices aren't big market movers, but market participants seem to be rethinking Friday's release of the December jobs report, which was much worse than expected.

Treasuries surged Friday in the wake of the jobs release, and extended their gains in Monday's session. Tuesday, however, there was heavy selling.

"Two of the driving forces of the selling pressure yesterday were eurodollar futures and MBS selling," says Tom Tucci, head of U.S. Treasury trading at CIBC World Markets. "[Philadelphia Fed president Charles] Plosser introduced the potential that the Fed would not reinvest MBS portfolio proceeds once QE is fully tapered. This is the first time I have heard that stance and may have been one of the factors in the MBS selling."

Chart 1 shows expected future yields on 3-month U.S. dollar deposits held in banks outside of the United States, known as eurodollars.

The curve can be used as a proxy for the market's expectation of the path of the Fed's policy rate.

The green line shows that at the close of trading last Thursday, before the release of the jobs report Friday, expectations were for a sooner and steeper path of rate hikes than at the close of trading Monday (red line), the peak of a two-day post-payrolls rally.

Today, however, the market is moving back closer to its pre-payrolls state as participants express skepticism over the weak jobs numbers. The idea is that given a plethora of other economic data points that point to robust labor market trends, the December jobs report may be an outlier.

"Very few bullish participants out there given the way the market underperformed yesterday," says Tom di Galoma, head of fixed income rates sales at ED&F Man Capital Markets.

The next big event is the release of December consumer prices data on Wednesday morning at 8:30 AM ET. Economists expect the headline annual inflation rate to have risen to 1.5% in December from 1.2% in November, reflecting rising food and energy prices, while the core inflation rate (which excludes food and energy prices) is expected to have been unchanged at 1.7%.

In its December monetary policy statement, the FOMC emphasized the distance of current inflation levels from its 2% target as a key justification for continued extraordinary monetary stimulus. If inflation surprises to the upside - especially the core measure - short-term interest rates will likely continue to rise as traders continue pulling forward expectations for when the Fed will begin hiking rates.