All Change?

Friday was a good day for my boss Ian Shepherdson who has been sticking his neck out since the beginning of the year with a call that the Fed would cut rates this year by more than the consensus believes. I recently joked with him that we were just one bad payroll report away from markets freaking out. That report landed on Friday, pushing already nervy markets into near meltdown. We know the drill; bonds soared, equities crashed, and “US recession risks” hit a headline near you. Of course, the Fed hasn’t cut rates yet, but even before Friday’s data, everyone expected the first cut in September. Expectations are now shifting towards a 50bp reduction, and further cuts in quick succession after that. The decision to hold rates in July is now freely being seen as a mistake.

Let’s get the obvious question out of the way? Are markets now going to trade themselves and everyone else into a US recession? It’s possible, but before we sit back and allow ourselves to be consumed by the red ink on the screen, I agree with Michael Brown that one key story here is the abject inability of markets to settle on a path for the Fed funds rate in the past six-to-nine months. You could drive a bus through the spread between market-implied expectations for the US policy rate between January and July.

More generally, it’s useful to put Friday’s data and market response into context. The simplest frame of reference is the distinction between a soft and a hard landing, which has dominated market conversations since hiking cycles in DM came to an end. The soft landing is defined here as a modest slowdown in growth, only a slight hit to employment, if at all, a relatively slow decline in interest rates and inflation falling back, but likely staying somewhat above target.

A hard landing, by contrast, comes in two versions. The first in which the seeds of a sharp slowdown and recession have already been sown, and central banks—in this case the Fed—will move aggressively, but late, to mop up. In the second version, central banks are forced to impose a recession on the economy to get inflation down quickly enough. In case you’re wondering, Friday’s price action was consistent with a hard landing, and one in which the Fed has been late to the party in mopping up. The difference between a soft and a hard landing—and the different versions of the latter—can be a difficult one to identify ex-ante. After all, what might feel like a hard landing in a given moment might be identified as a soft landing in the fullness of time, and vice versa; an apparent soft landing can suddenly and brutally morph into a hard landing, a scenario many investors and forecasters will be contemplating after Friday’s data. Every data point in the US, and elsewhere, between now and key September DM central bank meetings, will be weighed on this scale, by markets and forecasters alike.

Goodbye inflation, and thanks for the fish?

The lurch lower in US employment growth comes at a time when inflation in the main developed economies has been falling, with sticky services, but when short-leading indicators for inflation are ticking higher, or more aptly, forming a bottom. The end of deflation in China’s PPI is another upside risk to global inflation, mainly in goods, though commodity price inflation has recently reversed, taking the sting out of this particular signal, for now. Economists, strategists and investors have been poring over these data in the past year, attempting to pin down the monthly prints to two or three decimals in an attempt to extract a reliable signal for the next move by central banks. Friday’s reaction to the below-consensus NFP print is a hint that other data might now start to matter more. This could be the beginning of a volatile couple of months for markets, especially in relation to the already hyped monthly NFP print where the difference between 100k and 150k in any given month could just as easily be down to seasonals, survey sample period, weather or the infamous birth/death model as a reflection of anything in the real economy. The US labour market is weakening, but how quickly? Markets and forecasters will be spending a lot of energy trying to answer this question in the next few months, just as they will be looking closely in the broader hard data for confirmation of economic weakness. Will this just inflation data to take a backseat? In one sense, this depends on the inflation data, but it just might.

A final interesting aspect of Friday’s volte face in markets in response to a step-down in US employment growth is that it is happening in the context of a generalised upturn in global leading indicators, as of the end of the second quarter. The first chart below show that a diffusion index of OECD LEIs was still turning up strongly in June, accompanied by a positive, albeit weakening momentum in my cyclical equity index, here updated with the most recent data for the first week of August. The second chart shows that expectations that the Fed is about to aggressively front-load interest rate cuts are shifting at time when the global monetary policy easing cycle is already well under way. Granted, it is difficult to talk about a global easing cycle when the three main central banks are only barely started shifting towards easier policy, but the chart doesn’t lie in the end; the number of cutters has been out-numbering hikers for a while.

How will these indicators will change in light of a likely shift in the US labour market and growth, if that is indeed what we’re seeing? The most obvious call would seem to be a risk of a turn in global leading indicators in Q3, reflecting in part rising volatility in financial markets, but also a strengthening momentum in global monetary policy easing. What will the net effect of these two shifts be on global sentiment? It’s difficult to tell until we see further data, and how markets respond to them. After all, Friday’s price action was a bit panicky, and it is August, after all. Two things then to look out for in the next few months, a softening in global leading indicators and evidence that markets are shifting their focus from inflation to a broader subset of data, in the US and the rest of the global alike. All change?