U.S. Treasury bonds rallied after data showed American employers unexpectedly cut jobs in July, signaling challenges in the labor market that could dampen the Federal Reserve's willingness to raise interest rates.

The yield on the two-year Treasury note, which is highly sensitive to near-term monetary policy shifts, dropped as much as 9 basis points to 4.15% on Friday as traders reduced bets on further rate hikes in the coming months. The decline later narrowed to 5 basis points, settling near 4.19% as oil prices edged higher.

The Bureau of Labor Statistics reported Friday that nonfarm payrolls fell by 23,000 in July, while data for the previous two months was also revised sharply lower. The unemployment rate fell to 4.1%, and labor force participation continued to decline.

"The negative headline on total nonfarm payrolls was a complete surprise," said Tom di Galoma, Managing Director at Mischler Financial Group. "I think the Fed won't hike in September."

Strategists noted: "The low unemployment rate seems to be tempering part of the market's reaction on the fixed-income side, but with average job gains over the past three months at just 20,000, it's become much harder to justify a rate hike. I expect the bond rally to continue."

The data suggests the labor market may now be facing headwinds, following a surprisingly strong start to the year that had previously driven investors to price in additional rate increases. Based on interest rate swap pricing, traders now see roughly a 40% probability of a rate hike at the Fed's next meeting in September, down from nearly 60% before the data release.

"I wouldn't casually dismiss this report, because the revisions to nonfarm payrolls point to weakness," said Jeffrey Rosenberg, Senior Portfolio Manager at BlackRock Core Bond Trust. "The market hasn't overlooked this—short-end bonds are rallying, and rate hike probabilities have fallen sharply."

However, investors are still fully pricing in one rate hike by the end of the year. Fed Chairman Kevin Warsh's refusal to provide forward guidance has also made it harder for the market to gauge the policy path. Last week, the Fed held its key policy rate steady, though three officials dissented in favor of a hike.

In a Friday interview with Punchbowl News, President Donald Trump reiterated his preference for lower interest rates, while acknowledging that the Fed board votes on rate decisions and Warsh is just one member. The tone was milder compared to Trump's earlier harsh criticism of Warsh's predecessor, Jerome Powell.

The next major economic data point is the U.S. Consumer Price Index, due Wednesday. A surge in energy prices driven by the U.S.-Iran conflict has reignited inflation concerns, though last month's CPI came in below expectations, temporarily easing some worries.

"If the data over the next few months comes in a bit weak, especially on inflation, they may be reluctant to raise rates," said Stephanie Roth, Chief Economist at Wolfe Research. "They'll want to see how the data develops first."