An American Rate Bottleneck

But first things first.

The ‘Carry Trade Scare of 2024’ is firmly behind us. Just two weeks ago, the Nikkei experienced its worst crash in 37 years, as the Yen/USD carry trade unravelled. The US tech trade rolled back, and words like “Black Monday” floated in the air.  Two weeks later, the Nikkei has recovered all its losses, and US large caps are near their all-time highs. Why did the scare happen? One easy explanation is that this was a mix of de-leveraging, low volumes and possibly some algorithmic trading exacerbating what could have been a more shallow move. Another could be that the market sends us warning signs about impending instability.

There are three significant takeaways for investors:

1. One, investors happily and hastily bought the dip and returned to their holiday, ‘August nonsense’ might be equally applicable to ‘Black Monday’. The RSI indicator suggests that the markets are now close to ‘overbought’.
2. Two the Fed did not have to intervene. The move was so swift, and the buybacks were equally fast. One can’t help but wonder if central banks can even catch up to super-fast computers. What happens when buybacks are not swift enough? Will markets dive before policymakers have a chance to respond?
3. Three, this is a volatile market, even more so than standard volatility measures might suggest.

With the raucousness behind us, all eyes now turn to the US Federal Reserve. This week, the US central bank is having its annual meeting in Jackson Hole, where important policy announcements are often (but not always) made. Presently, markets expect the Federal Reserve to cut four times (down from five two weeks ago) by the end of the year. The question is not ‘whether’ the US central bank will cut rates, but by how much.

For 2024, the IMF projects 2.8% growth for the US, and just below 1% for the UK and the EU.

While the Bank of England and the European Central Bank have now both delivered their first rate cut, they can’t embark on a rate cutting cycle, even if their growth conditions are more challenging. Why? Because this is still a yield-hungry world and they risk a flight of capital to the US Dollar if Fed rates remain higher.

Thus, we would expect Mr Bailey and Ms Lagarde to be the most eager viewers of the Jackson Hole meeting.

Whereas we don’t really expect any big announcements out of Jackson Hole, we see that the arguments for rate cuts, vs ‘higher for longer’ are balanced.

On the one hand, we see rising unemployment. The US central bank has a dual mandate, inflation and unemployment (a licence to facilitate economic growth). After the latest unemployment figure (4.3%) the so-called Sahm rule was activated. The rule states that “When the three-month moving average of the national unemployment rate is 0.5 percentage point or more above its low over the prior twelve months, we are in the early months of recession”. The rule has been triggered 11 times since 1953 and yielded a false signal only once, in 1959 when a recession did indeed start five months later.

The other key indicator that a recession may be coming is the yield curve turning positive.

While the validity of both of these quantitative signals is well established, and while economic data have been pointing towards a slowdown, the evidence for a recession is not compelling. The economy has been growing at a healthy pace, and inflation is falling. PMI indicators do suggest that manufacturing and services activity has been slowing but nowhere near the point of a recession. While the Sahm rule may have a point, unemployment has been significantly below average for a long period. All it takes for the rule to activate is one very low point (3.5%) in the previous twelve months. As for the yield curve, its working isn’t magical. Rate hikes aim to curb aggregate demand. The time when inversions stop is usually the time when rate hikes begin to take a serious toll on the economy. This time around, the inversion lasted for two years. Yet we didn’t see the usual recession in year one. Instead, we see a modicum of economic growth and, more importantly, a very modest growth in the M2 supply of money. This informs us that at 5.5%, rates aren’t overly constrictive and the yield curve normalisation might not be the be-all and end-all signal of a recession.

Instead, we think that central bankers are right not to call victory over inflation. While goods inflation has been trending lower, mostly because of Chinese overproduction and massive output gaps, services inflation is still too high for comfort.

For central bankers to be at ease with rate cuts, they would need to see services inflation coming down towards its average, before Chinese producer inflation begins to climb towards its own average. If anything, markets should be focusing on services inflation.

It’s really simple: the longer the Fed waits to cut rates, the better the chance that services inflation will come down before China stops disinflating the world at the current pace.

Ultimately, we don’t expect Jackson Hole to yield a clear guide to rate cuts. Markets will probably be satisfied with most outcomes (which means risk assets can continue their rebound), except for a very hawkish outlook on rates, which the data would not support at this point. Our house view remains that we could see 1-2 rate cuts this year from the Fed and that we would not expect a firm rate cut cycle to initiate before 2025.

Market update

Markets continued to rebound this week, as strong US economic data made the prospect of an imminent recession seem less likely. Japanese stocks led the rebound, increasing by 6.2% in GBP terms as fears over the unravelling of the Japanese ‘carry trade’ subsided. US, UK and EU markets followed, rising over 2% each. The rebound was broad based, with all sectors of the stock market posting positive returns.

Softer than expected figures for US inflation (PPI and CPI) and strong retail sales caused markets to see a higher chance of a ‘soft landing’. Rate sensitive information technology and growth stocks outperformed during the week. The consumer discretionary sector also rallied on good earnings news.

Bond yields moved lower at the start of the week in reaction to inflation data, but jumped higher on retail sales data. US retail sales rose by 1% in July, more than three times the 0.3% increase expected by economists. Over the full week, US, UK and German 10-year government bonds moved by -6, -1 and +4 basis points respectively.

Macro news

UK GDP increased by 0.6% in the second quarter of 2024 (April to June), following an increase of 0.7% in the first quarter. On a year-on-year basis, real GDP increased by 0.9%. Services were the main driver of growth in the 3-month period and grew by 0.8%, offsetting 0.1% declines in both the production and construction sectors.

Headline inflation in both the UK and the US was lower than expected in July. UK consumer prices rose by 2.2% in the 12 months to July, lower than the 2.3% expected by economists, while US inflation increased by 2.9%, versus a consensus figure of 3.0%. In the UK, the headline figure was pulled down by lower-than-expected services inflation. Prices related to hotels, restaurants and recreation contributed negatively to services inflation in July, while being a source of strength in the previous month – likely reflecting the unwinding of a temporary ‘Taylor Swift effect’. Shelter inflation was the main driver of US inflation in July; shelter prices increased at a rate of 0.4%, twice the June rate of 0.2%. Prices for apparel and used cars and trucks decreased, however, at rates of 2.3% and 0.4% respectively in July. Core inflation was in line with expectations at a monthly rate of 0.2% and a year-on-year rate of 3.2%. The figures all but seal an interest rate cut by the Federal Reserve at its September meeting, according to Federal Funds futures prices.

The week ahead

On Wednesday this week, the US Fed will publish what will be closely watched minutes of its July monetary policy meeting. The Fed left the door open to a September rate cut last month with chair J. Powell acknowledging progress on inflation.

On Thursday the weekly report on initial jobless claims in the US will be released.

US Fed Chair J. Powell is due to deliver the keynote address at the central bank’s annual economic symposium in Jackson Hole, Wyoming on Friday. Markets will be laser-focused on what he signals about the pace and timing of rate cuts over the coming months. Several other Fed officials are also due to make appearances during the week including Fed Governor Christopher Waller, Atlanta Fed President Raphael Bostic and Fed Vice Chair for Supervision Michael Barr.