First Fed hike in December due to very strong job report

Today's labour market report was very strong and, therefore, economists now expect the Fed to deliver a 25bp rate hike at the December meeting. The market now prices close to 85% probability of a hike in December depending on the level of Fed funds after the first hike and, in all senses, close to as much as the market can price it ahead of the December meeting.

"We look for four further hikes in 2016, in line with the median projection within the FOMC, i.e. in total five hikes before end-2016. The market has priced slightly below three hikes in total before end-2016", says Danske Bank.

Overall, nonfarm payrolls increased by 271,000 in October, well above both forecast and consensus expectation. The total revision of August and September was +12,000 and thus the three-month average monthly job gain increased to 187,000. The increase in employment was driven by the private sector, which rose by 268,000. Manufacturing employment was unchanged. The unemployment rate declined from 5.1% to 5.0% and will very soon fall below the low end of the Fed's projected NAIRU range (4.9%). Part time employment for economic reasons is the lowest since 2008.

Average hourly earnings also surprised on the upside. Average hourly earnings rose 0.4% m/m in October, taking the annual growth rate to 2.5% y/y and thus wage growth is at the highest level in six years. Wage growth has been subdued for a long time despite the tightening in the labour market but now wage growth finally seems to have taken off. The UK experience is that wage growth can be subdued for a long time and suddenly increase very quickly. The increasing wage inflation means that the underlying inflation pressure in the US is increasing and is the main reason why economists look for four hikes in 2016.

In FX, relative interest rates will drive the final leg of USD strength, particularly against low yielders such as EUR, JPY, CHF, SEK and NOK. Over the coming month, the multi-year EUR/USD low at 1.0458 are to be tested again. However, Fed rate hikes should be 'sell the rumour, buy the fact' for EUR/USD, as it has been over the recent Fed hiking cycles. The longer term trajectory for EUR/USD is higher as the 'natural' flow in EUR/USD is the buying of EUR given the eurozone's large trade surplus and the likely closing of the eurozone's output gap in 2017.

 USD/JPY, is expected to move up to 124. GBP/USD is likely to be more insulated given that this should raise expectations of an earlier than priced Bank of England rate hike. Short term, economists expect higher US rates to pressure emerging markets and commodity currencies, although it is believed the impact will be offset somewhat by the likely stabilisation in China.

Following the strong labour market report, the market is now pricing a probability of a December rate hike close to 85%. economists have seen a 5-10bp move higher in US treasury yields across the curve, with the policy-sensitive 5Y segment suffering the most, and the curve 2Y5Y has steepened slightly.

The market prices the Fed Funds futures being around 70bp higher at end-2016, so slightly below three hikes of 25bp priced in total before end-2016. This is still below economists forecast and the Fed projections, which implies five hikes in total in 2015 and 2016, so the market is probably still capable of pricing in further rate hikes in 2016, adding further upside pressure, especially on the short-end of the US yield curve. However, the FOMC will be eager to tell the market that it has no plans to hike rates aggressively. Furthermore, the wider spread to European Government Bond (EGB) yields also attracts investors into US fixed income adding support, especially to the longer end of the curve. Overall, the risk of a further sell-off in the US fixed income market as relatively high. The recent move in US swap spreads into positive territory might be a warning that low liquidity could potentially exaggerate the current bearish move in the fixed income market.

"Today's report does not change our ECB view. We still look for an extension and expansion of the QE programme and deposit rate cut deeper into negative at the ECB December meeting. Hence, the market impact for EGB yields should primarily be felt at the long end of the European curve, as the ECB is still capable of keeping shorter yields on a tight leash", added Danske Bank.