JP’s Journal: Crisis? What Crisis?

Step back two weeks. World equity markets were in turmoil, led by Japanese and US tech shares. There were calls for an immediate cut in Fed Funds, with an emergency 50bps reduction being mooted.

When traders are on the wrong side of moves the calls for action inevitably grow loud. But it is not the Federal Reserve’s job to protect traders’ bonuses. At this point, the US bond market was factoring in five to six cuts of 25bps by January 2025, which would take US interest rates to around 4%. In tandem, 10-year treasury yields fell dramatically with the benchmark hitting 3.7%, from around 4.2% just a week earlier.

Last week saw a semblance of normalcy, bolstered by positive data. Encouraging inflation figures emerged in the US, with headline CPI inflation at 2.9% and core at 3.2%, both supportive of a 25bps reduction in September's Fed Funds rate. UK’s CPI inflation modestly increased from 2.0% to 2.2% in July, lower than anticipated, whilst the core rate fell from 3.5% to 3.3%. Importantly for the Bank of England, the decline in services inflation from 5.7% to 5.2% was larger than expected, helped by lower price pressures in hospitality.

There remain challenges for the Bank of England, especially around the spate of large pay settlements in the public sector and surprisingly robust employment data

The latest UK GDP figures brought positive news on the economic activity front. The second quarter saw a 0.6% quarterly increase in GDP, helped by higher industrial production and growth in construction, whilst consumer spending climbed by 0.2%. This came on top of bond friendly news on the labour market front, where average earnings growth fell from 5.7% to 4.5%, and the ex- bonus number declined from 5.8% to 5.4%. There remain challenges for the Bank of England, especially around the spate of large pay settlements in the public sector and surprisingly robust employment data, which saw the unemployment rate fall to 4.2%. Overall, the better economic news is likely to stay the hand of the Bank of England in September, with the next rate reduction likely in November.

In the US there were also signs that economic activity remains resilient. July retail sales beat expectations, with solid growth in a range of sectors including electronics and home furnishings, whilst there was a strong rebound in auto sales. Supporting this, initial jobless claims fell back from the previous spike caused by Hurricane Beryl.

Overall, data last week calmed nerves about a US recession. US 10-year treasury yields were broadly flat, trading in a range 3.8%-3.9%. In the UK, 10-year rates dipped to 3.8% mid-week but closed above 3.9%. The equivalent French government bond hovered just below 3%, with the spread to Germany back above 0.7%. Credit spreads narrowed for choice, reflecting the better tone in risk assets. There remains little new issuance in sterling credit which is helping keep the non-gilt credit spread below 1%.

The better economic news in the UK may not last and the public finances are not in a great shape. The UK is not unusual in this. But with a Misery Index (the unemployment rate plus the inflation rate) that has rapidly improved over the last 18 months, things do look better. Crisis? What Crisis?

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