All eyes on job market as Fed's rate-cut window narrows

By Karen Brettell

May 5 (Reuters) - The release of the U.S. employment report later this week will serve as a test of whether the economy remains resilient enough to keep the Federal Reserve's monetary policy on hold, or whether a softening labor market could revive the case for interest rate cuts that the war with Iran has all but buried.

Solid economic growth and concerns about war-driven inflation have left markets expecting no rate moves this year, a sharp change since January, when fed funds futures traders were pricing in two 25-basis-point cuts in 2026.

"The economic backdrop and the data have been quite resilient through the conflict," said Jonathan Cohn, head of U.S. rates desk strategy at Nomura. "Even without the uncertainty from Iran, one could make the case that the economy doesn't require meaningful easing at this point."

A clear sign of labor market deterioration could prompt Fed officials to start thinking about lower rates, analysts said, though even a very weak report might be unlikely by itself to shift the consensus at the U.S. central bank, given the strength of last month's employment report, other solid economic data and stubbornly high inflation.?Investors have been banking on lower rates to sustain increases this year in the prices of stocks and other assets.

Strong data has helped the case against rate cuts even if there is a near-term resolution of the war, analysts said.?The U.S. economy added 178,000 jobs in March, nearly three times the 60,000 forecast by economists in a Reuters poll, while the unemployment rate edged lower to 4.3%.

Benchmark 10-year Treasury yields have climbed to 4.43% from 3.94% before the war began on February 28, while rate-sensitive 2-year yields have risen to 3.94% from 3.38%. That broad repricing reflects markets coming to terms with a higher-for-longer reality for interest rates.

DISSENT AT THE FED OVER EASING PROSPECTS

There are few signs so far that easing is foremost on central bank officials' minds.?The Fed?held rates steady at its most recent meeting, but three policymakers dissented over language suggesting that the bias was toward rate cuts.

"Over the inter-meeting period, there was growing support for a more neutral stance on the future path of interest rates," said Vail Hartman, U.S. rates strategist at BMO Capital Markets.

Fed Chair Jerome Powell said last week in his post-meeting press conference that the U.S. central bank could drop its easing bias as soon as its June 16-17 meeting.

Analysts said the conditions supporting a cut in the fed funds rate from the current 3.50%-3.75% range had narrowed considerably.

U.S. economic growth regained speed in the first quarter as businesses boosted investment in artificial intelligence and government spending rebounded after a crippling shutdown.

Consumer spending also has remained resilient, although consumers are paying more for gasoline.

"If the Fed cuts, it's not going to be because we got good news on inflation data," Hartman said. "It's going to be because we got bad news on the labor side."

This labor market weakening would need to be seen in more than one report and most likely be marked by a sustained increase in the unemployment rate, he added.

Economists polled by Reuters expect the Labor Department on Friday to report a gain of 62,000 jobs last month, with the unemployment rate remaining unchanged at 4.3%.

INFLATION BAR REMAINS HIGH

Even if oil prices were to normalize following a ceasefire, analysts cautioned that inflation was already on a troubling trajectory before the conflict began, meaning a resolution of the conflict in the Middle East would remove one obstacle without fully clearing the path to lower rates.

"Inflation was already increasing before the oil shock even hit," Hartman said, adding there would be "some reluctance to conclude that we shouldn't be all that worried about inflation just because the oil issue has diminished in relevance."

Cohn pointed to several factors preventing the market from durably pricing in Fed tightening, including the pending Senate confirmation of former Fed Governor Kevin Warsh to replace Powell as head of the central bank, still-anchored long-term inflation expectations and what he called the Fed policy committee's "implicit dovish bias."

But Cohn cautioned that bias alone would not be enough to revive aggressive rate-cut pricing without a deterioration in economic data.

One factor that may have masked underlying economic softness is an unusually large wave of tax refunds, which has helped consumers absorb higher energy costs, said Michael Lorizio, head of U.S. rates and mortgage trading at Manulife Investment Management.

How quickly that buffer fades, and whether the impact of higher oil prices shows up in consumption or other economic data will be a key variable for markets assessing the Fed's path, he said.

For now, the bar remains high on both sides. Without a crack in the labor market, the case for rate cuts is hard to build. With inflation still elevated, the case for holding is easy to make.

"If you see the labor market data begin to crack, then cut expectations can reemerge in a more meaningful way," Cohn said. "Absent that, I think the market will struggle to get back all the way to what we were pricing pre-war."

(Reporting by Karen Brettell; editing by Colin Barr and Paul Simao)