Slowing inflation clears way for extended Fed pause

Market fears of a pending US recession appear to be fading as economic data holds up relatively well despite the scale of rate hikes taken by the Federal Reserve. The 2s10s curve has dropped from an inversion of as much as -106bps at the end of H1 to closer to -75bps as of mid-August. The move has largely been in the form of bear steepening as 10yr yields have pulled higher by almost 27bps to rise above 4% while the 2yr yield has dropped about 5bps to around 4.84%. Stronger than expected Q2 GDP performance for the US (2.4% annualized growth vs expectations of 1.8%) along with a slower but hardly worrisome July non-farm payrolls report will chip away at expectations that the US economy will shrink meaningfully in the coming quarters. Easing inflation indicators are another sign of positivity but we think the Federal Reserve will stay cautious and want to see more sustained evidence of easing prices before they move to an accommodative stance.

Labour market remains resilient

The US economy is slowing but no indicators are showing signs of acute strain, yet. The July non-farm payrolls of 187k along with a downward revision to the June print (185k) were the smallest labour market gains since the end of 2020 but were accompanied by an acceleration in jobs gains in the household survey and an unemployment rate still near record lows at 3.5%. Average hourly earnings are also slowing but at 4.4% y/y in July remain solidly above pre-pandemic levels. Labour demand still looks to be strong, if less robust than a few months ago: the ratio of job openings to unemployed at 1.6:1 in June is down from nearly 2:1 at the start of the year but compares very favourably with a 2015-19 pre-pandemic average of about 0.9:1.

Activity data is also cooling though hardly falling off a cliff. The main disappointment in recent months has been manufacturing where the ISM index has been sub-50 since November 2022. But the services ISM has actually improved in the June-July prints after hitting a 2023 trough of 50.3 in May. Retail sales are steadily—if slowly—expanding while durable goods ex-transport showed a respectable 0.7% and 0.5% m/m for May and June respectively.

Consumers also look to be in fair health this far into a rate hiking cycle. Real personal spending surprised in June, rising by 0.4% m/m, while there have been tentative improvements in consumer sentiment. However, the University of Michigan consumer sentiment remains near series lows at just 71.6 for July, below its April 2020 level of 71.8 when the Covid-19 pandemic was in full swing.

The apparent improvement in sentiment shown by the steepening of the 2s10s curve has been accompanied by rising equity markets—the S&P 500 rose 3% in July—and the strongest monthly gain in oil prices since January 2022 (WTI futures added 17% and have trended even higher in early August).

Inflation is the key

But the critical metric for the past two years for the US economy has been inflation. Its post pandemic surge to more than 9% in mid 2022 forced the Federal Reserve into aggressive policy tightening of 525bps, culminating in what we expect will have been the final hike at the July FOMC (25bps). Inflation indicators are now easing—the July headline CPI print came in largely in line with expectations of 3.2% y/y while the m/m change in core CPI of 0.2% for both June and July was the slowest pace since the start of 2021. Signs of disinflation will likely expand in coming months, particularly as the Fed expects shelter inflation to slow or even turn negative by mid-way through 2024.

Even as price pressures ease, we don’t think the Fed will be in a rush to move to accommodative policy. Momentum in the US economy could surprise on the upside for the rest of 2023, particularly if consumer sentiment improves, which raises the risk that inflation could once again flare up. Energy prices could keep upward pressure on headline CPI though we expect the Fed will show limited concern as wholesale price gains are driven more by exogenous factors like OPEC+ production policy than domestic demand. We expect that the Fed will hold rates unchanged for the rest of 2023 and only shift to an accommodative policy stance—via cutting the Fed funds rate—towards the middle of 2024. Disinflation signals should be stronger by then, along with softer economic data, allowing the Fed to cut rates without generating another inflationary impulse. We expect three 25bps cuts in 2024, one in H1 and two spread over H2.