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MARKETS

US stocks summited to new record highs in a post-holiday session characterized by low volume and liquidity. Investors found renewed confidence in the latest labour market report, fueling speculation that the Federal Reserve might soon cut interest rates.

The US economy added 206,000 jobs in June, slightly exceeding expectations. However, revisions to the previous two months painted a less rosy picture, and the unemployment rate unexpectedly edged up to 4.1%.

Let’s first acknowledge that headline NFP figures might be somewhat inflated. As a result, the market's reaction to the better-than-expected payrolls was tempered.

“You’ve got strong job creation, you have payroll jobs still coming in strong, even though there’s an argument that they may be a bit overstated but still they’re strong.” Chair Powell

Job Number Overstated?

But the uptick in the unemployment rate had macro purists clamouring for rate cuts. The subtle rise to 4.1% flagged by the Sahm Rule—developed by former Fed economist Claudia Sahm—signals a potential recession, suggesting a half-point rise in the rolling three-month jobless rate average above the previous year's low. This should more than counter the Fed officials' ongoing equivocation. Bond traders seem to agree, with 2-year yields (the Fed Fund proxy) dropping nearly 9 points to 4.60% and the global benchmark US 10-year yields falling 7 points to 4.28%.

Sahm Rule indications (1960 – 2024)

Initially, the mixed jobs data confounded stock pickers; however, equities eventually rebounded after a series of bobs and weaves thanks to September rate cut pricing, which is pretty much odds-on.

The week's data—a mish-mash of softness, including Wednesday's jobless claims, layoffs, and missed forecasts in private sector hiring—painted a picture of weakening growth. The Atlanta Federal Reserve's "GDPNow" estimate fell to 1.5%, and US economic surprises hit their most pessimistic in two years. This data practically screams for the Fed cut in September.

Let’s be clear: inflation isn’t conquered, and central bank rate hikes had little to do with its decline. The significant disinflationary forces were the easing supply shocks from the pandemic and the war in Ukraine. Looking ahead, the global post-war order outside of the UK, where political apathy rules, the world is tilting to the right where in the US, sweeping new tariffs, curbs on immigration, and tax cuts, a unified Republican government might reverse whatever progress America has made in the inflation fight and underscoring the worst fears of those inclined to fret over deficits and debt. The belief that central bankers can manage inflation around an arbitrary target will be tested repeatedly, and they are likely to fail more often than succeed. A good reason to put some gold in the portfolio?

For now, investors are turning a blind eye to potential pitfalls. In the first half of the year, global equity funds saw a net inflow of $242 billion, with stock ETFs pulling in $454 billion, offsetting $210 billion of outflows from mutual funds.

Regarding the S&P 500's performance, it’s always tricky to determine whether investors are chasing stocks higher due to a policy put or if inflows are pushing up stocks—or maybe both. In the grand scheme of things, it probably doesn't matter much.

FOREX MARKETS

The current factors influencing the Pound's value are primarily political, revolving around the Labour Party's substantial majority. This political stability is expected to create a positive environment for the UK economy as it picks up speed, especially with the fading impact of the energy price shock and the return of real income growth. Despite the Labour Party's relatively modest spending plans of only GBP 7.3 billion, businesses will likely gain more confidence, leading to increased investment. Furthermore, it is anticipated that relations with the EU will gradually improve."

The future of the British pound depends mainly on the policies of the Bank of England. After a quiet period leading up to the vote, officials from the Bank of England are expected to begin speaking again next week and could very well lean dovish. The first interest rate cut is predicted in August, followed by two more in 2024. As a result, it is possible that the value of the British pound will lag behind other G-10 currencies and could potentially leak lower against the greenback. The critical question is whether policy or politics will drive the dollar's direction.

Some of the market’s reluctance to price in more easing is likely tied to the increasing chances of Donald Trump winning the US presidency in November. The assumption is that Trump’s protectionist and tax-cut policies could decelerate the Fed’s easing measures.

Simultaneously, concerns within the Democratic Party about President Biden’s cognitive abilities continue to grab headlines. Should Biden withdraw, the dollar might weaken slightly as markets might interpret the Democrats' move as a strategic effort to improve their chances ahead of November. However, until new presidential polls are published with the new Democratic candidate, it is hard to envision markets significantly unwinding USD longs driven by bets on a Trump victory. Apart from Michele Obama, who could generate substantial honeymoon bounce poll numbers, most other Democratic options might struggle against Trump in a head-to-head poll.

Data-Dependent Fed Takes Note of Mounting Economic Slowdown

The Federal Reserve, ever alert to economic shifts, is noting increasingly clear signs of a slowdown following last year's rapid growth. The Bloomberg Economic Surprise Index shows the economy frequently underperforming forecasters' expectations. Concrete indicators, including labour market data, housing, and retail sales, reflect these downside surprises alongside softer survey data.

The June employment report highlighted a significant downward revision of 111,000 jobs for April and May payrolls, bringing the Q2 average monthly gain down to 177,000 from Q1's 267,000—a steeper decline than anticipated. The unemployment rate unexpectedly rose for the second consecutive month to 4.1% from May's 4.0%, marking a 0.4 percentage point increase since the beginning of the year and a 0.7 percentage point rise since April 2023's low of 3.4%. Wage pressures are also easing, with average hourly earnings growth falling to a three-year low of 3.9% in June due to weakening labour demand and improving supply. This softer labour market is a critical mechanism for the Fed's restrictive monetary policy, which aims to reduce aggregate demand and alleviate overall inflation pressures. Recent increases in initial and continuing jobless claims suggest more industries are nearing a turning point, where further demand or profit declines could lead to additional layoffs.

In the past two weeks, we've observed a sharp decline in May's home building and new/existing home sales, along with another significant drop in the Conference Board’s Leading Economic Index, and this week confirmed the intensifying economic slowdown, with the ISM Manufacturing PMI unexpectedly dropping to 48.5, pushing the manufacturing sector further into contraction. However, the biggest surprise was a rare 5-point drop in the ISM Services PMI to 48.8, marking the service sector’s second dip into contraction territory in three months and only the third since the Fed began raising interest rates in March 2022.

The June FOMC Minutes highlighted several downside risks, including a sharper-than-expected slowdown in aggregate demand, a marked deterioration in labour market conditions, and financial strains on lower- and moderate-income households leading to a sharp reduction in consumer spending. The Fed’s median 2024 GDP growth forecast of 2.1% Q4/Q4 always seemed optimistic with the soft data reeling. Supporting this, as mentioned above, the Atlanta Fed’s GDPNow tracker for Q2 dropped to 1.5% SAAR this week.

Several FOMC participants emphasized that with the labour market normalizing, further demand weakening could result in a more significant unemployment increase than in the recent past, where lower labour demand was more apparent through fewer job openings. We consider these downside growth risks seriously, reinforcing our forecast that the Fed will begin cutting policy rates at the September meeting. Even if core PCE price inflation doesn't improve year-over-year due to unfavourable base effects, as long as it doesn’t worsen significantly and we see more labour market weakening, most FOMC voters will likely gain the confidence to believe inflation is sustainably returning to target.

With the marked slowdown in nonfarm payroll growth in Q2 and the rising unemployment rate at 4.1%, labour market rebalancing appears to be ongoing. The next critical event for financial markets is next week’s June CPI report, where another mild result is expected. However, concerns are mounting about the 15% increase in WTI oil futures and the 11% rise in gasoline futures prices over the past month. This could lead to higher monthly headline inflation in the July reports if there are no offsetting improvements elsewhere.

( All data pulled from BMO Economics)

TWEET OF THE WEEK

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