S&P 500: +0.09% | Dow: -0.27% | Nasdaq: +0.40%

Stocks finished the holiday-shortened week essentially flat, but beneath the surface, the market received an important message: the economy may still be too strong for the Federal Reserve to comfortably ease monetary policy.

The S&P 500 finished Friday at 7,718.60, the Nasdaq at 26,506.99 and the Dow at 53,414.25. For the week, the S&P 500 gained just 0.1%, the Nasdaq rose 0.4%, while the Dow slipped 0.3%.

The bigger story, however, was not the modest movement in stocks. It was the sharp reaction in interest rates following Friday’s employment report.

The Big Story: The Labor Market Refuses to Break

Friday’s August employment report delivered a surprise.

The U.S. economy added 162,000 jobs — nearly three times the roughly 56,000 economists had expected. The unemployment rate remained at 4.1%.

That is an important result because investors had increasingly been expecting enough economic softness to give the Fed room to begin lowering rates. Instead, the employment data suggested that the economy still has meaningful underlying strength.

The immediate market reaction was predictable: Treasury yields moved higher and expectations for a September rate increase jumped.

The market is now assigning roughly a 58% probability to a September hike, although that probability has moved considerably from day to day.

Translation for investors: the Fed may have less freedom to cut rates than the stock market had hoped.

Treasury Yields Become the Market’s Pressure Point

This is where the story becomes particularly important for investors.

The 2-year Treasury yield moved up toward 4.37%, while the 10-year yield approached 4.8% following the jobs report.

Higher long-term yields matter because they affect virtually every major asset class.

Higher yields can:

• Increase borrowing costs for consumers and businesses

• Put pressure on housing and commercial real estate

• Reduce the relative attractiveness of stocks trading at elevated valuations

• Increase the discount rate applied to future corporate earnings

• Make high-quality bonds more competitive with equities

This is why we are paying particularly close attention to the Treasury market.

The stock market can continue rising even with higher yields — but eventually the level and speed of the move begin to matter.

Are We Seeing Another 2022–23?

One of the most interesting questions facing investors is whether today’s rise in Treasury yields represents a temporary adjustment or the beginning of another sustained rate cycle.

There are similarities to 2022–23.

In both periods, markets initially expected monetary policy to become easier than the data ultimately justified. Stronger economic activity and persistent inflation then forced investors to reconsider how quickly the Fed could ease.

But there is also an important difference.

Today’s Treasury market is dealing with a much larger supply of government debt, substantial fiscal borrowing and a term premium that can place additional upward pressure on longer-duration yields.

That means the 10-year Treasury does not necessarily need the Fed to raise short-term rates dramatically for yields to remain elevated.

For investors, this makes the long end of the yield curve increasingly important.

The Good News: The Economy Still Has Momentum

There is an important positive interpretation of the jobs report.

A strong labor market is not inherently bad for stocks. Quite the opposite.

Employment growth supports consumer spending. Consumer spending supports corporate revenues. Strong economic activity supports earnings.

The problem occurs when economic strength becomes strong enough to keep inflation elevated and prevents the Fed from easing monetary policy.

That is the balancing act investors are facing right now:

Strong economy = good for earnings.

Strong economy + persistent inflation = potentially bad for interest rates and valuations.

The market needs economic growth — but not so much inflationary pressure that the Fed has to keep tightening.

Oil Adds Another Layer of Risk

Energy markets are making that balancing act even more complicated.

Renewed U.S.-Iran tensions pushed oil sharply higher during the week, with Brent crude approaching $93 per barrel and WTI moving above $91.

Higher oil prices can eventually feed into headline inflation and inflation expectations.

That creates a potentially uncomfortable chain reaction:

Higher oil → higher inflation expectations → higher Treasury yields → less room for Fed easing → greater pressure on equity valuations.

The good news is that energy prices can reverse quickly if geopolitical tensions ease.

For now, however, oil remains an important variable that could complicate the Fed’s inflation fight.

Next Week: Inflation Takes the Stage

The jobs report may have changed the rate debate, but the Fed still has another major piece of information coming before its September meeting: inflation.

Investors will be watching the upcoming Producer Price Index and, especially, the August Consumer Price Index.

That data could determine whether the recent increase in rate-hike expectations becomes more firmly established — or begins to reverse.

If inflation comes in hotter than expected:

Markets could price in an even greater probability of additional Fed tightening.

If inflation comes in cooler than expected:

Bond yields could retreat and expectations for Fed easing could return.

And if inflation lands somewhere in between, the market may continue to grind sideways while investors wait for greater clarity.

Our View Going Into the Fall

We remain constructive on the underlying U.S. economy and corporate earnings, but we believe investors should be increasingly selective as the market moves deeper into September.

The bull market remains intact. The S&P 500 is still up approximately 13% for the year, while the Nasdaq is up about 14%.

But the environment is becoming less forgiving.

The biggest risk is not necessarily a recession.

It is the possibility that economic growth remains strong enough to keep inflation elevated, forcing interest rates to remain higher for longer than investors currently anticipate.

That scenario could produce more volatility even while corporate earnings remain healthy.

This is precisely the type of environment where diversification, liquidity and risk management become increasingly important.

Bottom Line

The market ended the week almost exactly where it started — but the interest-rate outlook changed materially.

The economy is still producing jobs. Inflation remains above the Fed’s comfort zone. Oil prices are elevated. Treasury yields are rising. And the probability of another Fed rate increase has moved meaningfully higher.

That does not mean the bull market is over.

It does mean investors should stop assuming that lower rates are automatically coming to the rescue.

The next major market signal may come not from earnings, but from inflation.

For now, the message from the bond market is clear:

The Fed may not be finished.