The Economy Looks Strong. So Why Are Stocks Worried?

Good news for workers is bad news for asset managers. Go figure?

The US economy delivered the kind of jobs report USNFP politicians usually frame and hang on the wall.

Employers added 162,000 jobs in August, nearly triple the 56,000 economists expected, while unemployment held at 4.1%. Even better, previous months were revised higher and more people entered the labor force.

Wall Street responded by selling stocks. The S&P 500 SPX fell 0.4% Friday, the Dow DJI lost 0.5% and the Nasdaq IXIC slipped 0.3%. Treasury yields jumped and the dollar DXY strengthened.

Welcome to one of markets' favorite paradoxes: sometimes a strong economy is precisely what investors don't want to see.

🏦 The Fed Changes the Equation

The missing piece is interest rates USINTR . The Federal Reserve is struggling to return inflation to its 2% target, and Chair Kevin Warsh recently warned policymakers still have "work to do" unless they become confident inflation is cooling sufficiently.

A resilient labor market gives the Fed more freedom to raise rates because employment appears strong enough to absorb tighter monetary policy.

Friday's report, in that sense, changed expectations almost immediately. Traders briefly pushed the probability of a September rate hike to around 65%, from roughly 55% before payrolls landed.

📈 Why Stocks Care About Bond Yields

Higher expected interest rates quickly spill into the Treasury market. The policy-sensitive two-year yield jumped to as high as 4.42%, while the 10-year yield briefly topped 4.81% after the report. The Yield Curves tool is always handy to keep track of those market-shaking moves.

Higher yields increase borrowing costs for companies and reduce the present value of future corporate profits.

That last point hits growth stocks particularly hard. Much of their valuation depends on earnings expected years into the future. When rates rise, investors apply a larger discount rate, essentially marking those future dollars down when calculating what they're worth today.

The economy can therefore improve while the price investors are willing to pay for its companies falls.

🔥 Inflation Makes This Cycle Different

Naturally, strong employment and solid economic growth are welcome news. The complication today is that inflation remains uncomfortable while energy prices are adding another headache.

Brent crude finished last week up 7.6%, while US crude gained 10%, as renewed US-Iran fighting tightened energy markets.

Meanwhile, US services activity accelerated in August and new orders reached their strongest level in three and a half years. That's encouraging for growth, but accompanying input-price pressures give the Fed another reason to remain cautious.

Strong demand + strong employment + expensive energy is a combination central bankers tend to examine rather carefully.

🧊 Would Weak Data Be Better?

Here's where things get even stranger. A moderately weaker economy could help stocks if it convinces traders that another rate increase is unnecessary. Treasury yields could fall, borrowing conditions could ease and investors might become willing to pay higher valuations for equities.

There is, however, a line. If economic data deteriorates far enough (reminder to keep an eye on the Economic Calendar), the conversation shifts from "Great, the Fed can stop hiking" to "Wait, are corporate earnings about to fall? Is it all over?"

Markets often want something close to goldilocks: enough growth to keep profits expanding, without so much demand that inflation forces central banks to tighten further.

👀 CPI Gets the Next Word

That makes this week's inflation numbers considerably more interesting.

Producer prices USPPI arrive Thursday, followed by CPI USCPI on Friday, with economists expecting annual core inflation to ease slightly to around 2.4% from 2.5%. The Fed then meets September 15-16.

A cool inflation print could give policymakers room to look past Friday's employment strength. Another hot reading would combine resilient jobs with persistent inflation and strengthen the argument for tighter policy.

Off to you: How are you preparing for inflation data down the week? And what’s your outlook on interest rates? Share in the comments!