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Why US Jobs Market Is Going to Get a Lot Worse

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Weak U.S. jobs data on Friday confirmed the worst trading week this year for European and U.S. stocks, and now analysts are warning that investors should brace for further trouble ahead as fiscal tightening begins to take its toll.

Friday's jobs report came in well below expectations, raising concerns that the recovery in the world's largest economy is weakening. March's participation rate was at its lowest since 1979, according to the U.S. Bureau of Labor Statistics. Just 88,000 jobs were added to the economy last month, although the unemployment rate fell to 7.6 percent from 7.7 percent in February.

"In the labor market, at least, we see a real risk of even worse news down the line," Ian Shepherdson, chief economist at Pantheon Macroeconomic Advisors said in a research note on Monday.

(Read More: US Job Creation Plunges, but Rate Drops to 7.6%)

Weakening labor demand, not rising layoffs, is the key problem with the U.S. economy, according to Shepherdson. The weakening demand is mostly coming from smaller firms that are below the radar of the Institute for Supply Management (ISM) survey, which reflects national factory activity.

The National Federation of Small Business job survey has done a decent job in foreshadowing movements in payrolls in recent years, according to Shepherdson, and it's this report—due to be released on Tuesday—that's warning of troubled waters ahead, he said.

"While actual job creation appears to be rising, plans to create jobs [in March] took a dive, falling 4 points to a net zero percent of small employers who plan to increase total employment. It seems that the stamina for growth is waning," William C. Dunkelberg, chief economist for the NFIB said in a press release last week.

Looking at the figures, Pantheon's Shepherdson said there could be a degree of respite in the official employment numbers for the next couple of months, before a distinct change.

(Read More: Unemployment Rate Dip Offers Little Reason to Celebrate)

"The outlook then turns bleaker again. The survey does not signal an outright decline in payrolls over the next few months, but we cannot be sure it has bottomed out yet," Shepherdson said.

He cited fiscal tightening as the major reason behind the reverse. At the start of the year, the payroll tax that funds Social Security was raised two percentage points to its 2010 level of 6.2 percent. This was the largest component of tax increases approved by Congress in the resolution of the "fiscal cliff" that many believe will cause a significant hit to U.S. growth.

"You can't take more than 1.5 of GDP (gross domestic product) out of the economy more or less overnight and expect nothing bad to happen," Shepherdson said. "Markets—especially the Treasury market—are having a rethink of the fiscal-tightening-doesn't matter-much hypothesis. Good. It never made any sense."

U.S. equities responded negatively on Friday to the soft jobs data, government bond yields fell with the benchmark 10-year Treasury falling to its lowest yield so far this year. The dollar also depreciated against European currencies in response.

(Read More: Job-Seeking Teens Might Get a Break This Summer)

"The data support our view that the strong U.S. data flow in January and February is likely to give way to weaker data in (the second quarter), as fiscal headwinds are reflected in slower growth in demand, activity, and employment," Barclays said in a research note on Monday. "Although we have recently raised our forecast of (first quarter) GDP growth to 3.5 percent, which matches our latest tracking estimate for the quarter, we have kept our (second quarter) forecast at 1.5 percent."

By CNBC.com's Matt Clinch

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