Wall Street is braced for the Federal Reserve to start tapering back its bond-buying program in September, if job growth in August is anything like it was in July.
That's the current conventional thinking about the Fed's unconventional quantitative easing program, which has helped balloon its balance sheet to $3.65 trillion.
In the market's view, the August employment report, released at 8:30 a.m. ET Friday, has become the key data point for the Fed, since employment is an important metric for its easy money policies. Economists expect 180,000 nonfarm payrolls were created in August, the average rate of monthly job growth during the recovery, according to Thomson Reuters data. They also forecast no change in the 7.4 percent unemployment rate. Job growth in July was 162,000.
"I would characterize it as more of the same. We're seeing decent job growth but nothing that would make you consider it to be explosive," said Stephen Stanley, chief economist at Pierpont Securities. "This rate of job growth is eventually going to get to a better pace, but it's going to take time…I think the Fed is less dependent on data than they let on." Stanley expects to see 160,000 jobs added and an unemployment rate of 7.4 percent.
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Traders said the market expects a slightly better-than-expected jobs report, and they were counting on the Fed to begin paring back on its buying. An unknown factor, however, is the potential for U.S. military action against Syria if Congress approves a military strike on the country for using chemical weapons on its citizens.
"I think they decided in the spring that QE was actually doing more harm than good. It's hard to imagine anything short of a disaster that would change their assessment here. The other wild card hanging over everyone's head is this situation with Syria but it may not rise to the level where it would affect the Fed," said Stanley.
Winding down QE has been the topic of much angst in global markets since the Fed first suggested a pullback in its $85 billion monthly purchases in early May. U.S. bond yields have risen and stocks, while still higher, have struggled against rising interest rates. The 10-year went from a low of 1.61 percent in May to above 3 percent in late trading Thursday. The rise in U.S. rates has sent ripples around the world, with a painful exodus of capital from emerging markets and higher bond yields globally.
"The winds have changed here. Economic data is picking up some. Once the Fed started talking about reducing purchases that was a real thing to the market," said Brian Edmonds, head of interest rate trading at Cantor Fitzgerald. "It looks like we will continue to see pressure on rates. What would put the genie back in the bottle , that would be much weaker data."
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But the data is not weakening or strengthening in any consistent fashion. Durable goods and industrial production have been weaker than expected, but the four-week average for jobless claims is at a six-year low. This week's ISM data for manufacturing and services was much better than expected, and that encouraged traders to expect a stronger-than-consensus jobs report.
ISM manufacturing data showed the strongest expansion in two years in August, and ISM services data on Thursday jumped to the highest level in nearly eight years and the employment component of the index was at a six-month high. Stocks gained slightly on the report, but bond yields made a major move Thursday, with the 10-year yield at its highest level since July 2011. The bias in the bond market is towards selling, and there are expected to be continued redemptions.
"I think there's a reasonable amount of optimism built in for the employment report," said Ian Lyngen, senior Treasury strategist at CRT Capital. He said 3 percent is a key zone for the market.
"That will be quite a battleground. Given how elevated flows are now and given the psychological impact of 3 percent as opposed to the high 2s, I think you will see people in there defending that level and people pushing it as well. It should prove itself a meaningful technical test." Lyngen said a jobs report over 200,000 could easily drive the 10-year to 3.08, 3.10 percent. "The average move for nonfarm payroll day is 12 basis points." A weak number, on the other hand, could bring in some buyers.
Besides the ISM data, traders were also expecting a better than consensus number after ADP's private sector employment report Thursday showed job gains of 176,000.
"Everything suggests we should be in the same range we've been getting – 175,000 to 200,000," said Mark Zandi, chief economist at Moody's Analytics. Zandi said unless the job growth falls below 150,000 or the unemployment rate shoots dramatically higher, the Fed should decide at its Sept. 17/18 meeting to begin a slow wind down in bond buying. It has pledged, however, to keep short end rates low for the foreseeable future.
"I think they taper. I think the bar is pretty low for a September tapering. My guess is it's $15 billion, anywhere from $10 billion to $20 billion, and I think they just do Treasurys," said Zandi. He said a report presented by Northwestern University professors at the Fed's Jackson Hole meeting last month made a strong case for continuing mortgage-backed securities purchases, since they have a more direct impact on rates. The Fed is buying $40 billion a month in mortgages and $45 billion in Treasurys, and it is expected to slowly trim its purchases, finishing about the middle of next year.
Mesirow Financial chief economist Diane Swonk says she expects 165,000 jobs and an unemployment rate of 7.4 percent. "I think the sense is we're sort of in this pattern. It's not horrific. It's not enough to stop the Fed from tapering," she said. "We'd have to have not only failure of this number completely — 130,000, 140,000 — but there would have to be downward revision to past data. Something that would change our view of history."
Swonk said she expects the tapering to be a relatively small amount. "It will be focused on Treasurys. I think they're going to do it gradually. What's interesting is this September move. The reason it's important is it gives you two meetings to set up a course that has some momentum no matter who takes over at the Fed," she said.
Traders say the uncertainty surrounding who will run the Fed is impacting the market. Former Treasury Secretary Larry Summers is seen as a strong possibility since he seems to be favored by President Obama, over Fed Vice Chair Janet Yellen, Wall Street's favored candidate.
The 2-year yield has moved to its highest level since May 2011 in part because of speculation that a Summers-led Fed may not have the same view on forward guidance as Ben Bernanke's Fed, which Yellen would likely have maintained. The forward guidance now shows the Fed keeping short-term rates at zero until 2015. The 2-year was yielding 0.51 percent late Thursday.
"I think when the betting money shifted away from Yellen to Summers, I think there was some downgrading of the forward guidance and that was proper. You have someone who was set up initially as a frontrunner," Stanley said. "I think the markets see anyone other than Yellen as going to be less dovish than she is. The market perceives him as some big hawk, and that's absolutely wrong. This is a guy that has very conventional liberal ideological views which has been very evidenced in his policy advocacy with the administration over the last couple of years. He might be less dovish at the margin than Yellen but I think he markets have grossly exaggerated how much they would differ."
—By CNBC's Patti Domm. Follow here on Twitter @pattidomm.