“The Market Is Convinced That Powell Will Cut Rates At The First Sign Of Trouble… And It’s Correct”

By Philip Marey, Senior US Strategist at Rabobank

Speculation about Powell’s speech at Jackson Hole continues to affect markets as the 10 year US treasury yield climbed further yesterday – now hovering around 3.05% – and EUR/USD remains below parity. The S&P500 lost 0.22%. Yesterday, we noted the sharp contrast between the Fed’s consistent message that in the current situation price stability has priority over full employment and the markets’ expectation of an early Fed pivot. By repeating this message during his speech scheduled on Friday, Powell is not likely to convince the markets. As long as he sticks to the Fed’s fairy tale that they can bring down inflation without causing a recession, the markets are likely to cling to the idea that the Fed will cut rates at the first sign of trouble.

In fact, the soft-landing story lacks any economic logic. The claim that wage pressures can be reduced by decreasing the ratio of job openings per unemployed, without substantially increasing unemployment, is wishful thinking on the Fed’s part. This ratio is a reflection of job matching efficiency, which can only be decreased through active labor market policies, such as training, as we explained repeatedly in our FOMC specials. This is outside the scope of the central bank, instead it is the job of federal, state and local governments, or businesses. A recession with a substantial increase in unemployment, terminating the wage-price spiral, is the only way to get inflation back to the Fed’s 2% target. Perhaps brutal honesty could realign Fed plans and market expectations.

Meanwhile, the PMIs provided by S&P Global painted a bleak picture for the global economy. In yesterday’s Global Daily we already noted that the French PMIs for August indicated the first economic contraction in 18 months.

The German manufacturing PMI surprised to the upside and rose to 49.8 in August from 49.3 in July. In contrast, the German services PMI headed deeper into contractionary territory, to 48.2 from 49.7. The composite PMI fell to 47.6 from 48.1. Consequently, S&P Global’s press release was titled “Downturn in German private sector economy deepens in August.” According to S&P Global, “The deepening downturn was linked by surveyed businesses to a combination of factors that included uncertainty, high inflation and rising interest rates, all of which weighed notably on demand.”

The Eurozone PMIs all deteriorated: the manufacturing PMI moved down slightly to 49.7 from 49.8, but there was a more substantial decline in the services PMI to 50.2 from 51.2. As a result, the composite PMI fell to 49.2 from 49.9. S&P Global’s title was “Eurozone business activity down for second month running as service sector growth grinds to a near-halt.” According to S&P Global, “cost of living pressures sapped demand in the service sector, leaving activity only just inside growth territory, while manufacturing remained in a downturn midway through the third quarter of the year.”

The UK PMIs had good and bad news. According to S&P Global, the UK private sector moved closer to stagnation in August, while inflationary pressures cooled slightly. While the services PMI was only slightly lower than last month, falling to 52.5 from 52.6, the manufacturing PMI collapsed to 46.0 from 52.1. Consequently, the composite PMI declined to 50.9 from 52.1. “The rate of expansion was the weakest for 18 months and pointed to only a marginal increase in output. The loss of momentum was often linked by panel members to relatively muted customer demand as well as shortages of both labour and inputs.” However, on the bright side “survey data signalled a further easing in the rate of input cost inflation across the UK private sector.”

The US PMIs were also disappointing. The manufacturing PMI fell to 51.3 from 52.2, but this is still in expansionary territory. However, the services PMI headed deeper into contractionary territory to 44.1 from 47.3. The composite PMI declined to 45.0 from 47.7. According to S&P Global, “US private sector firms signalled a sharper fall in business activity during August. The decrease in output was the fastest seen since May 2020. The rate of contraction also outpaced anything recorded outside of the initial pandemic outbreak since the series began nearly 13-years ago.” To make things worse, US new home sales plunged by 12.6% in July after a 7.1% drop a month earlier. This is yet another data point confirming the weak state of the housing market.

Relatively good news came from Eurozone economic confidence, which unexpectedly improved to -24.9 in August from -27.0 in July. However, this is still worse than the lowest point during the outbreak of COVID (-24.5), which was already below the troughs of the Global Financial Crisis (-22.4) and the Eurozone sovereign debt crisis (-21.4).

In a Q&A session with the Wharton Minnesota Alumni Club, Minneapolis Fed President Kashkari said that the US economy is “at maximum employment and at very high inflation. So this is a completely unbalanced situation, which means to me it’s very clear: we need to tighten monetary policy to bring things into balance.” He added that “when inflation is 8 or 9 percent, we run the risk of unanchoring inflation expectations and leading to very bad outcomes that would have to cause us to have to be very aggressive – Volcker-esque –  to then re-anchor them.”