Strong Jobs, Higher Hike Risk

AI will be a significant disinflationary force, increasing productivity and bolstering American competitiveness.

—Kevin Warsh

The market’s view of the Fed has shifted dramatically over 2026, from expecting cuts to increasingly pricing the risk of hikes. The Iran war and the months-long closure of the Strait of Hormuz had already pushed investors to consider whether higher energy and related goods prices would force the Federal Reserve toward additional tightening. Last Friday’s nonfarm payrolls report reinforced that shift: payrolls rose 172,000, the six-month moving average moved to 92,000, and leisure and hospitality added 70,000 jobs. The reaction across markets was direct: the 2-year Treasury yield moved above 4.1%, traders lifted the probability of a Fed hike by year-end, the S&P 500 fell 2.6%, and the Nasdaq dropped 4.2% on the day.

The Bloomberg U.S. Labor Market Surprise Index spent much of 2025 in negative territory, consistent with a labor market that was cooling versus expectations and a market pricing a more benign Fed path. The index has turned positive again, and the 2-year yield has followed, highlighting that labor data remain a key driver of front-end rates.

Labor surprises have turned positive, and the 2-year yield has responded. Event-related hiring explains part of the May strength, and AI may eventually help the supply side, but investors still face stronger-than-expected labor demand. Strong payrolls carry more policy weight when the labor force is not expanding normally, and a higher 2-year yield tightens financial conditions through discount rates, cash yields, borrowing costs and risk appetite.

A strong jobs report is usually good news for household income, consumer spending and corporate revenue. In the current inflation backdrop, strong labor demand also raises the probability that wage pressure and service-sector inflation remain too firm for the Fed to declare victory. The 2-year yield is the market price that captures this tension most directly.

Leisure and hospitality accounted for 70,000 of the May gain, well above its recent average of about 35,000. Some of that strength likely reflects hiring by hotels, travel businesses and restaurants ahead of the upcoming World Cup. That tempers the signal from the headline number, but event-related hiring still draws from a labor market with limited slack.

Artificial intelligence is also part of the Fed debate. Fed Chair Kevin Warsh has argued that AI will be a significant disinflationary force because it should raise productivity and American competitiveness. That may prove true over time, but the current AI cycle looks more inflationary in the near term because the buildout is already increasing demand for data centers, electrical equipment, chips, memory, power, cooling systems, construction and specialized labor. The productivity dividend remains uncertain, while the buildout is already moving through the economy. Monetary policy can respond to current labor and inflation data, but it will be hard-pressed to lean on productivity gains that have not yet appeared in the data.

Labor surprises have turned positive, and the 2-year yield has responded. Event-related hiring explains part of the May strength, and AI may eventually help the supply side, but the data in front of investors still point to stronger-than-expected labor demand. Strong payrolls carry more policy weight when the labor force is not expanding normally, and a higher 2-year yield tightens financial conditions through discount rates, cash yields, borrowing costs and risk appetite.

Between the Lines is a weekly blog by DoubleLine Portfolio Managers Sam Garza, Joseph Mezyk and Quant Analysts Fei He, CFA and Sunyu Wang that breaks down topical macro and market issues. For questions or suggestions please e-mail us at betweenthelines@doubleline.com. The views and opinions expressed herein are those of the authors and do not necessarily reflect the views of DoubleLine Capital LP, its affiliates or employees.