Markets Rally on Soft Jobs Data, But the Fed's Path Remains Cloudy

The U.S. labor market ended 2025 on a soft note, delivering a report that has extended the recent market rally by reinforcing expectations of prolonged low interest rates. The core figures tell a story of a fragile, uneven transition. In December, nonfarm payrolls rose by a seasonally adjusted 50,000, a significant miss against the Dow Jones estimate for 73,000 and a stark slowdown from the 2024 average monthly gain of 168,000. For the full year, payroll gains averaged just 49,000 a month, less than a third of the previous year's pace.

The headline unemployment rate fell to 4.4 percent, slightly below forecasts. Yet this decline was driven by a drop in labor force participation, not strong hiring. The labor force participation rate held at 62.4%, and the number of people not in the labor force who wanted a job remained elevated. In other words, the rate fell because people are leaving the workforce, not because they are finding jobs.

This sets up a stark sectoral divergence. While employment continued to trend up in food services and drinking places, health care, and social assistance, the retail sector shed 25,000 jobs. This pattern of strength in services and weakness in goods highlights a labor market in structural flux, not a simple cyclical slowdown. The report presents a "muddy view," as companies report low hiring while households show employment gains, complicating the Fed's task of gauging true economic momentum.

Market Reaction and the New Policy Calculus

The market's initial reaction to the soft jobs data was one of relief, not alarm. Stocks rallied to new highs on Friday, with the S&P 500 and Nasdaq both posting record closes. This move reflects a classic interpretation: weak payroll growth reinforces the narrative that the Federal Reserve has room to stand pat, removing a near-term overhang on asset valuations. The rally was broad-based, with all three major averages finishing the week in the green.

Yet the rally is built on a recalibration, not a reversal, of the policy path. The data has pushed back expectations for easing, but not altered the long-term trajectory of low rates. The market is now pricing the next Fed rate cut as not occurring until June, a delay from earlier expectations that had the easing cycle starting sooner. This shift is a direct response to the report's mixed signals. While the headline unemployment rate fell, the weak job creation and the "no-hire, no-fire" theme suggest the labor market is cooling more slowly than previously hoped. The Fed, which has already cut rates three times since September, appears likely to hold its ground for a period.

The Congressional Budget Office's recent projection provides a longer-term framework for this new calculus. It forecasts the Fed funds rate will settle at 3.4% by late 2026, with unemployment peaking at 4.6% this year. This paints a picture of a prolonged period of low, but not ultra-low, rates. The CBO's outlook, which incorporates Trump administration policies, expects inflation to remain above the Fed's 2% target in the near term due to tariffs and strong demand, justifying a cautious approach. The bottom line is that the soft jobs report has extended the current holding pattern, but the fundamental setup for a gradual, terminal easing cycle remains intact. The market's record highs are a bet that this extended pause will be brief.

Forward-Looking Risks and Key Watchpoints

The soft December report has extended the Fed's pause, but the new policy calculus is defined by structural headwinds and a longer-term trajectory. The most persistent of these is the emergence of a "no-hire, no-fire" economy, where companies are holding staff but not expanding. This is not a temporary dip but a recalibration, as the full-year average of 49,000 monthly payroll gains signals a labor market cooling more slowly than hoped. This creates a fragile equilibrium: enough hiring to keep unemployment low, but not enough to generate wage pressures or signal robust growth.

Policy itself is a key constraint. The Congressional Budget Office projects that higher tariffs and increased demand from the Trump administration's tax cuts will keep inflation above the Fed's 2% target in the near term. This is the fundamental reason the easing cycle is terminal, not aggressive. The CBO forecasts the Fed funds rate will settle at 3.4% by late 2026 and remain there through 2028. In other words, the Fed's work is done; the market's job is to price in a prolonged period of low, but not zero, rates.

Against this backdrop, two variables will determine whether the current holding pattern extends or if a new phase is triggered. First is the trajectory of the 10-year Treasury yield. The CBO projects it will rise gradually to 4.3% by the fourth quarter of 2028. This matters because it sets the tone for mortgage and long-term borrowing costs, influencing housing and capital investment. A faster climb would signal stronger growth or inflation, pressuring the Fed to reconsider its terminal rate.

Second is the labor force participation rate. The recent decline in the headline unemployment rate was driven by a drop in participation, not hiring. If this trend persists, it could mask underlying weakness and complicate the Fed's mandate. A sustained low participation rate would also support the CBO's growth forecast, which expects real GDP growth to slow to an average of 1.8% in 2027 and 2028 as fiscal support wanes. The key watchpoint is whether participation stabilizes or falls further, as this will be a leading indicator of the economy's true health and the Fed's next move.

The setup is one of extended patience. The market has priced in a delay to easing, but the structural features-weak hiring, policy-driven inflation, and a rising long bond yield-point to a gradual, terminal cycle. The critical variables are now not the next Fed meeting, but the path of the 10-year yield and the labor force. Watch those, and you'll see whether the current holding pattern is a pause before a new phase, or the new normal.