New York — Wall Street closed sharply higher on Friday, propelled by a stunning government report that showed U.S. employers shed 23,000 jobs last month, an outcome that upended expectations of continued job creation and sent a powerful signal to investors that the Federal Reserve may soon relent on its aggressive rate hikes.

The Labor Department's monthly employment report, released at 8:30 a.m. Eastern, revealed that nonfarm payrolls contracted in July for the first time since late 2024, confounding economists who had penciled in a gain of roughly 150,000 jobs. The unemployment rate, meanwhile, ticked up to 4.2% from 4.1% in June, further underscoring the sudden cooling in the labor market.

The Dow Jones Industrial Average leaped 341 points, or 0.9%, to close at 38,912. The S&P 500 gained 1.2%, and the tech-heavy Nasdaq Composite surged 1.6%. All three major indexes posted their second straight weekly advance, with the S&P 500 notching a 2.5% rise for the week and the Nasdaq climbing 3.1%.

Treasury yields fell sharply as investors rushed to price in a more dovish Fed. The yield on the 10-year note dropped to 3.78% from 3.94% on Thursday, its steepest one-day decline in months. The two-year yield, which is more sensitive to Fed policy expectations, slid to 3.45%.

"This is the kind of data the Fed has been waiting for," said Emily Carter, chief investment officer at Horizon Capital Management in New York. "We have been in an environment where every strong number seemed to justify another rate hike. Now, with jobs actually shrinking, the central bank has a clear reason to pause — and maybe even start thinking about cutting."

The unexpected contraction in employment comes at a critical juncture for the Fed. The central bank has raised its benchmark interest rate by 525 basis points since early 2024, pushing it to a range of 5.50% to 5.75%, in an effort to tame inflation that had peaked at 8.5% in late 2023. While inflation has since moderated to 3.1%, the Fed has maintained a hawkish stance, warning that more tightening may be needed to bring price pressures back to its 2% target.

Friday's jobs report, however, injects a new element of uncertainty into that narrative. The largest job losses were concentrated in the leisure and hospitality sector, which shed 12,000 positions, and retail trade, which cut 8,000 jobs. Manufacturing and construction also posted modest declines. The only bright spots were health care and government, which added 5,000 and 2,000 jobs, respectively.

"The labor market is showing unmistakable signs of fatigue," said Mark Tanaka, senior economist at Stone Harbor Analytics in Chicago. "This is not just a blip. The trend has been softening for several months, and now we have a clear negative reading. The Fed will have to take this seriously."

Market participants reacted swiftly. Futures on the fed funds rate, which track expectations for the central bank's benchmark rate, swung to price in a nearly 70% probability of a rate cut at the Fed's September meeting, up from less than 40% just a day earlier. By the end of the year, traders now anticipate at least two quarter-point cuts.

"The market is pricing in a pivot, and it is doing so with remarkable speed," said Sarah Liu, a portfolio manager at Apex Asset Management in San Francisco. "We are seeing a classic risk-on move. Equities are rallying, bonds are rallying, and even gold is up. The only thing getting crushed is the dollar."

The dollar index, which measures the greenback against a basket of major currencies, fell 0.8% to its lowest level in three months, as traders bet that the Fed would soon join other central banks in easing policy.

Not everyone, however, is convinced that the job market is truly in trouble. Some economists pointed out that the July data could be distorted by seasonal factors, including the end of the school year and summer hiring patterns. The Labor Department also revised down its previous two months' numbers by a combined 12,000 jobs, slightly reducing the overall picture of strength.

"One month does not make a trend, especially when we have seen such strong job gains earlier this year," said James Holloway, chief U.S. economist at Global Insights in Washington. "The Fed is likely to wait for more data before making any major policy shift. But the market is clearly hoping for relief."

Friday's rally brought the S&P 500 to within 3% of its all-time high set in March. The comeback has been fueled by a string of better-than-expected corporate earnings reports and growing optimism that the economy can achieve a so-called soft landing, where inflation cools without triggering a deep recession.

Still, the jobs report adds a new layer of complexity. If the labor market continues to weaken, the Fed may face pressure to cut rates aggressively, potentially reigniting inflation. On the other hand, if the economy stays resilient, the central bank may hold steady, frustrating investors who have already priced in easier policy.

For now, Wall Street is celebrating the prospect of a less restrictive Fed. The question hanging over the market is whether this celebration is premature or the beginning of a sustained rally.