Overview: The December employment report brought another round of grim news, with the non-farm business sector firing workers at a pace matching some of the deepest post-war recessions. In December non-farm payrolls dropped 524K or 0.4% m/m (consensus 524K, DB 502K). On top of this, employment was revised lower by a net of 154K for the prior two months. The unemployment rate jumped 0.5pp to 7.2% (consensus 7.0%, DB 6.9%) and is now at its highest level since 1993.

Initially financial markets took the report lightly, with little reaction in US bond yields and equities trading slightly higher. One explanation might be that the Wednesday's ADP estimate of -693K had prepared the market for some even more negative data. However, as the news was absorbed, sentiment soured with bond yields drifting lower and equities losing terrain.

Details: The trend in the labour market is now exceptionally weak. Over the past three months private payrolls have declined by an average of 516K per month, with the service sector shedding 305K jobs and goods producing sector shedding 211K jobs on average.

Aggregate working hours declined even faster than the payrolls as businesses are scaling down on the average workweeks. Over Q4, aggregate working hours are down by 7.7% AR. Adjusting for the trend in labour productivity, this indicates a contraction on non-farm GDP of 5.7% q/q AR.

With the rapid rise in unemployment, slack is now building very fast in the labour market. Even so, average hourly earnings remains relatively steady at just below 4.0% y/y as wage dynamics are relatively sticky. However, due to the severe retrenchment in aggregate hours, our payrolls income proxy now indicates that nominal income growth is declining at a pace of almost 3%.

Assessment & Outlook: There is little doubt that the shock to credit markets in the wake of the Lehman failure in Autumn has caused an usually strong reaction among businesses. The combination of a liquidity squeeze and a sharp drop in demand growth has forced businesses to reduce workforces, run-down inventories and cancel investments at an unusually sharp pace to free up liquidity. This is now putting extraordinary downward pressure on the economy and adds further to the self-propelling negative dynamics of a recession.

We expect Q4 GDP to drop by around 5% annualised, followed by a further - but somewhat milder - contraction in Q1. This means that we are likely to see further sharp decline in payrolls data in the coming months, but that the pace of decline should begin to moderate in the spring. Unemployment will continue to rise fast. Our forecast is a peak slightly below 9% by end 2009 or early 2010.