Relax, Take It Easy

August 02, 2024

Elias Haddad

Relax, Take It Easy

Financial markets worry the Fed is reacting to slowly to early signs of softer US economic activity. We don’t.

Today’s US July non-farm payrolls report will be a significant driver of US interest rate expectations.

Swiss inflation remained muted in July. SNB has room to ease further.

The USD index is trading near the lower end of a multi-week range. Global stock markets are selling-off on disappointing tech earnings and a deeper contraction in US manufacturing activity. The ISM manufacturing index dropped to an 8-month low at 46.8 in July (consensus: 48.8) from 48.5 in June.

Meanwhile, US Treasuries surged across the curve (with 2-year yields at the lowest since May 2023) on concerns the Fed is reacting to slowly to early signs of softer US economic activity. Indeed, Fed funds futures adjusted lower to imply nearly 90bps of easing by year-end versus 70bps earlier this week.

In our view, the US economy is holding up reasonably well suggesting the Fed is unlikely to cut the funds rate as much as is currently priced-in. The Atlanta Fed's GDPNow model is tracking Q3 growth (seasonally adjusted annual rate) at 2.5% following real GDP growth of 2.8% in Q2, and the US S&P Global services PMI rose to a 28-month high at 56.0 in July.

Nevertheless, the Fed is increasingly worried about the US labor market with Chair Jay Powell warning Wednesday he “would not like to see material further cooling in the labor market.” As such, today’s US July non-farm payrolls report will be a significant driver of US interest rate expectations (1:30pm London).

Non-farm payrolls are expected to rise 175k in July following gains of 206k in June. For reference, the average non-farm payrolls monthly gain over the past 12 months is 220k. The unemployment rate is projected to remain at 4.1% on an unchanged participation rate of 62.6% while average hourly earnings are forecast to rise 0.3% m/m and ease two ticks to 3.7% y/y. Weaker US job gains can further weigh on US Treasury yields and USD. But stronger Job gains can be the catalyst for a USD relief rally and a modest correction in Treasuries.

Beyond today’s action, one reason behind our longer-term bullish USD view is the favourable US productivity landscape. US productivity (GDP/hours worked) increased more than expected in Q2 by 2.3% q/q (consensus: 1.8%) vs. 0.4% q/q in Q1 (revised up from 0.2%). Annually, productivity growth eased two ticks to 2.7% but is running above its post-war average of 2.1%. Rising productivity leads to low inflationary economic growth which translates to higher real interest rate and an appreciation in the currency over the longer term.

Swiss July CPI data matched consensus. Headline CPI fell -0.2% m/m vs. 0% in June and printed at 1.3% y/y in July for a second consecutive month. Also, core CPI fell -0.3% m/m vs. -0.1% in June and printed at 1.1% y/y in July for a second consecutive month. Bottom line: the Swiss National Bank (SNB) has scope to ease further as annual inflation is tracking below its Q3 projection of 1.5%. This is a drag for CHF.

GBP is underperforming and Gilts are outperforming on expectations the Bank of England (BOE) will dial-up rate cuts. Before yesterday’s BOE interest rate decision the swaps market implied a policy rate of 4.00% over the next 12 months. The swaps market is now pricing a policy rate of 3.75% in the next 12 months.

Yesterday, the BoE slashed the policy rate 25bps to 5.00% noting “twelve-month CPI inflation was at the MPC’s 2% target in both May and June”. In our view, the bar for an aggressive BOE easing cycle high:

First, the decision to cut was a close call. The vote split was 5-4 with the 4 dissenters supporting the case for no policy change. Notably, Governor Andrew Bailey voted with the majority for a cut while Chief Economist Huw Pill preferred to maintain the rate at 5.25%

Second, the BOE warned “monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation returning sustainably to the 2% target in the medium term had dissipated further.”

Third, the BOE projects stronger GDP growth, flat unemployment rate and a moderate rise in CPI inflation in the second half of this year. Indeed, the BOE cautioned “there is a risk that inflationary pressures from second-round effects will prove more enduring in the medium term.”

The risk to our view is tighter UK fiscal policy which can leave the BOE more room to ease policy. UK Chancellor of the Exchequer Rachel Reeves paved the way this week for higher taxes in the upcoming October 30 budget. Reeves warned of a £22bn (0.8% of GDP) funding shortfall that needed to be filled and announced emergency savings totalling £5.5bn. According to Reeves, “there will be more difficult decisions around spending, around welfare, and around tax.”

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