• USD rebound has room, but downtrend holds.

USD can build on its post-FOMC meeting gains next week as US-G6 yield spreads show little scope to move further against USD. Incoming data won’t change that dynamic. On Tuesday, S&P Global releases the September PMIs for the US, Eurozone, UK, and Japan. The Riksbank is expected to keep rates on hold at 2.00%, but risk is a cut. On Thursday, the Swiss National Bank is poised to keep rates at 0.00%. On Friday, the spotlight is the US August PCE report. 

Fed’s Safety Dance

At the September 16-17 meeting, the Fed opted for a “risk-management cut”, not a sharp policy unwind. As was widely expected, the FOMC cut the target range for the Fed funds rate 25bps to 4.00-4.25% after keeping them on hold since January. The biggest dovish take from the FOMC is that “The Committee…judges that downside risks to employment have risen”. That suggests more easing is in the pipeline if the US labor market shows ongoing weakness.

Indeed, the updated FOMC 2025 median fed funds rate projection implies two more 25bps rate reduction by year-end to a target range of 3.50-3.75% (3.625%) which is largely in line with futures pricing. Unsurprisingly, there was one dissent in favor of a 50bps cut (Fed Governor Stephen Miran) and no dissent for keeping rates unchanged.

Everything else points to a shallow, gradual Fed easing cycle. First, the FOMC median funds rate projection still implies 1 cut in both 2026 and 2027 and the longer run rate is unchanged at 3.0%. Second, real GDP growth was revised higher across the forecast horizon, the unemployment rate was adjusted a tick lower for 2026 and 2027, and inflation was tweaked two ticks higher for 2026. Third, Fed Chair Jay Powell sounded cautious on the scope for further easing describing the latest cut as a “risk-management cut.”

In our view, the risk is the Fed turns more dovish by the time of the December 9-10 FOMC meeting because policy remains restrictive and upside risks to inflation are not materializing.

Five Indicators Flashing Yellow

Five of the six monthly economic indicators used by the National Bureau of Economic Research (NBER) to date recessions are flashing weakness consistent with a policy stance that is too tight.

(1) Real personal income excluding transfers has stalled. The decline in job openings to unemployed workers points to softer wages growth ahead.

(2) Real personal consumption spending is growing below trend. Rising job insecurity is likely to push households toward higher savings, retraining any meaningful pick-up in consumer spending.

(3) Real manufacturing and trade industries sales are contracting. The ISM manufacturing exports orders index remains below the 50 boom/bust level indicative of continued weakness in this sector.

(4) Industrial production is growing at trend and the outlook is encouraging. The rising ISM manufacturing new orders-to-inventories ratio suggest firms may need to ramp-up production as demand is outpacing supply.

(5) Monthly payroll gains are close to zero growth. In fact, the economy added just 29k jobs on average in June, July, and August, well below the breakeven number for keeping the unemployment rate steady - estimated to be between 80k and 100k.

(6) Labor force growth is virtually flat. Lower immigration and lower labor force participation can further restrict labor supply growth. Fewer workers entering the market reduces potential GDP growth, which in turn dampens demand for goods and services. Firms may respond by curbing hiring, feeding into a self-reinforcing downturn.

The labor market data is the most important driver for the Fed and the most critical data for monitoring downside risks to the economy now. As such, the pace of decline in the Fed funds rate will be driven by the three remaining monthly non-farm payrolls reports for the year (October 3, November 7, and December 5).

Inflation contained

Progress towards the Fed’s 2% inflation goal may be stalling, but upside risks to prices are not martializing. The policy-relevant headline PCE deflator has yet to reflect the rise seen in the ISM prices paid indexes, which may now be topping-out. More importantly, wage growth is running around sustainable rates consistent with the Fed’s 2% inflation goal given annual non-farm productivity growth of around 2%.

Bottom line

Our base case is for the Fed to pivot more dovish by year-end, which will weigh on the USD and further fuel the rally in equity markets. Two risk scenarios could keep the Fed anchored to its patient easing guidance: US inflation quickens, or economy enters a Goldilocks state. The first scenario is USD negative, implying higher likelihood of stagflation. The second scenario is USD positive. We see the first risk scenario as more likely.