Fed Holds Firm: Dollar Strength and Bond Yields in a Resilient Labor Market

The U.S. labor market's surprising resilience, coupled with simmering tariff-driven inflation, is likely to keep the Federal Reserve on the sidelines longer than markets expect. This prolonged policy patience will underpin the dollar's strength against major currencies and compress bond yields, particularly in short-dated Treasuries. Investors should pivot toward tactical trades that capitalize on these trends.

Labor Market Resilience Anchors Fed Policy

The May 2025 jobs report revealed a labor market that remains stubbornly robust. Nonfarm payrolls added 139,000 jobs, with gains concentrated in healthcare (+62,000), leisure and hospitality (+48,000), and social assistance (+16,000). While the unemployment rate held at 4.2%, the more telling metric is the stable employment-to-population ratio (59.7%) and the decline in long-term unemployment to 1.5 million—a sign of persistent labor demand.

Crucially, wage growth, though modest (3.9% year-over-year), has not decelerated as swiftly as the Fed hoped. This, combined with sticky core inflation, leaves policymakers in a bind. The Fed's June 2025 policy statement emphasized “ongoing labor market tightness” as a key risk, signaling no urgency to cut rates despite a 4.25%-4.5% federal funds rate.

Tariffs Ignite Inflation—Fed's Hands Are Tied

While headline inflation dipped to 2.4% in May, core inflation (excluding volatile food and energy) remained elevated at 2.8%. The real threat lies ahead: tariff-driven price spikes. The Budget Lab estimates that effective tariffs will push core PCE inflation to 3.6% by Q4 2025, far above the Fed's 2% target.

Tariffs are already reshaping consumer prices. Clothing prices surged 28% short-term, while motor vehicle costs jumped 13.6%. Even food prices saw a 2.2% uptick. These pressures are structural, not cyclical, as companies exhaust inventory buffers and face unavoidable cost pass-through.

The Fed's dilemma is clear: easing prematurely risks letting inflation anchor at elevated levels. Chair Powell's June testimony made this explicit: “The labor market's durability and tariff-induced cost pressures mean patience is the safest path.”

Implications for FX and Bond Markets

Dollar Strength: The Fed's delayed easing will keep the U.S. dollar competitive. The DXY index, which fell 5% in 2024 amid rate-cut expectations, is poised for a rebound. Look for strength in USD-crosses with rate-cut-heavy central banks:
- Long USD/JPY: The BOJ's reluctance to exit ultra-loose policy creates a yield differential.
- Long USD/CHF: Swiss inflation is tame, but the SNB's cautious rate stance will lag the Fed.

Bond Market Compression: Short-dated Treasuries (2-5Y) will underperform as the Fed's pause limits their rally potential. Meanwhile, long-dated Treasuries (10Y+) face pressure if inflation expectations rise further. The 2s10s yield curve, already inverted at -0.5%, could steepen modestly if the Fed signals a 2026 cut—but not before.

Investors should:
1. Sell 10Y Treasuries: If core PCE hits 3.6%, yields could rise to 4.5%—a 50bp jump from current levels.
2. Buy 3M T-bills: Short-term bills offer safety amid Fed uncertainty and yield 4.2%, versus 3.8% in 2024.

Risks and Trade-offs

The Fed's path hinges on two variables:
1. Tariff Rollbacks: If U.S.-China trade talks produce meaningful concessions, core inflation could ease faster, allowing rate cuts.
2. Labor Market Fraying: A sustained rise in unemployment above 4.5% would force the Fed's hand.

For now, the base case favors a Fed hold through late 2025. This environment rewards dollar bulls and short-duration bond holders. As the old Wall Street adage goes: “Don't fight the Fed”—and the Fed is still tightening its policy reins.

In conclusion, the interplay of resilient jobs and tariff-fueled inflation will sustain dollar strength and keep bond yields elevated. Investors ignoring these forces risk being left behind in a market still shaped by policy patience.