US resilience has strengthened the case for a September rate rise

The US economy has just made the Federal Reserve's September decision considerably harder. August nonfarm payrolls rose by 162,000, far above the 56,000 economists had expected, while July's initially alarming loss of 23,000 jobs was revised to a gain of 21,000. Unemployment remained at 4.1%, even as the labour force expanded by 683,000 people and the participation rate edged up from 61.4% to 61.6%.

There are reasons not to take the headline entirely at face value. Leisure and hospitality accounted for 62,000 jobs and local-government education another 42,000, meaning those two areas alone produced almost two-thirds of the monthly increase. Seasonal effects may also have flattered the rebound. Even allowing for that, however, the report went a long way towards dispelling fears that July marked the beginning of a much sharper deterioration in employment.

The services sector reinforced the message. The ISM services index rose from 54.1 to 55.4 in August, comfortably ahead of expectations, while new orders reached their strongest level in three and a half years. The less reassuring detail for the Fed was prices. The input-price index climbed from 70.3 to 72.6, suggesting that resilient demand, higher energy costs and lingering supply constraints are keeping inflation pressure alive.

Markets initially pushed the probability of a September Fed increase to roughly 65% after the payroll report. By this morning that had settled back to about 58%, leaving investors unusually divided little more than a week before the 15-16 September meeting.

That puts this week's inflation data firmly in charge. Producer prices arrive on Thursday, followed by CPI on Friday. Economists expect headline CPI to remain at 3.4% year on year, while core inflation is forecast to ease from 2.5% to 2.4%. A benign report could give policymakers enough room to wait. A firmer reading, particularly in underlying prices, would substantially strengthen the case for a quarter-point increase and put Chair Kevin Warsh's Jackson Hole warnings about persistent inflation back at the centre of the debate.

The bond market is imposing its own form of tightening

Central banks are no longer the only source of tighter financial conditions. Government borrowing costs have climbed sharply across the developed world, increasingly challenging the assumption that economies and equity valuations can comfortably absorb higher-for-longer interest rates.

After Friday's employment report, the US 10-year Treasury yield traded around 4.8%, with the two-year yield briefly above 4.4%. The significance lies less in a few basis points either way than in how widespread the move has become. Japan's 10-year government bond yield has broken through 3% for the first time since 1996. German and French 10-year yields have reached levels last seen in 2011 and 2008 respectively, while British 30-year borrowing costs remain close to three-decade highs.

There is more behind the sell-off than expectations for the next Fed decision. Higher oil prices have revived inflation concerns, government borrowing requirements remain enormous and investors are demanding more compensation to hold long-duration debt. US federal debt has now crossed $40 trillion. At the same time, Alphabet, Amazon, Meta, Microsoft and Oracle have issued about $220 billion of debt this year as they fund the extraordinary build-out of AI infrastructure.

This may be the most important cross-asset constraint in the market at present. Sovereign yields feed directly into mortgage rates, corporate financing costs and government debt-service burdens. They also raise the return investors can earn without taking equity risk. Strong earnings have so far allowed stocks to live with that competition, but the hurdle is moving steadily higher.

Europe is facing an energy shock rather than a broad inflation relapse - for now

The euro area has its own inflation problem, although the details are more encouraging than the headline suggests.

Eurostat's flash estimate put August inflation at 3.3%, up from 2.9% in July. Energy was overwhelmingly responsible, with annual energy inflation accelerating to 14.3%. Meanwhile, core inflation eased from 2.5% to 2.4% and services inflation slowed from 3.3% to 3.0%. In other words, Europe is dealing primarily with an external energy shock rather than clear evidence that domestic inflation has begun spiralling again.

That distinction will matter when the ECB meets on Thursday. A quarter-point increase in the deposit rate to 2.50% is fully priced, and every one of the 65 economists surveyed in the latest Reuters poll expects the move. Most still think that will be enough.

The disagreement is over what comes afterwards. Deutsche Bank has changed its forecast and now expects another 25-basis-point increase in December, taking the deposit rate to 2.75%. Its shift reflects concern that the energy shock could last longer than previously assumed.

The ECB therefore faces an awkward balancing act. If higher oil and gas prices remain largely confined to headline inflation, pausing after September would make sense. If they start feeding into wages, inflation expectations or broader services prices, the central bank may have to tighten again even as economic growth remains fragile.

Oil has returned to the centre of the macro story

For markets, oil is again the variable capable of upsetting almost everything else.

UKOil rose 8.7% last week and finished Friday at $95.89 a barrel, while USOil climbed by roughly 9.5% to $91.30. Prices pushed higher again in early trading today, leaving UKOil around the $97 mark as renewed US-Iran military exchanges kept concern about Gulf supply at the forefront.

The physical disruption matters more than the headline price alone. Only four commodity vessels crossed the Strait of Hormuz on Thursday, compared with a recent daily average of roughly 15. At the same time, US retail diesel has reached a record $5.85 a gallon. Diesel is particularly important because its cost works its way through trucking, agriculture, construction and manufacturing long before households necessarily feel it directly at the petrol pump.

There are still reasons not to assume another immediate supply collapse. Iraq has raised exports, and a sizeable geopolitical premium is already embedded in crude prices. The sharp rally has therefore reflected fear of what might happen as much as a fresh loss of barrels from the market.

That does not make the risk benign. Quite the opposite. A sustained UKOil price around or above $100 would squeeze household purchasing power while simultaneously lifting headline inflation. The uncomfortable consequence would be weaker real growth alongside pressure on central banks to remain restrictive. Bonds and equities can each cope with parts of that story; the combination is far more difficult.

China is improving, but the recovery is still unbalanced

China's private-sector surveys offered some encouragement in August. The PMI rose from 50.9 to 51.5, with output and new orders strengthening and new export business growing at its fastest pace in six months.

Services also improved. The private services PMI rose from 50.4 to 51.4, helped by stronger domestic demand, although it was still the second-lowest reading of the past 14 months. That sits awkwardly beside the official data. China's official non-manufacturing business-activity index remained at 49.0 in August, below the 50 level separating expansion from contraction, while the official manufacturing PMI was also still below 50 at 49.8.

The contrast captures China's broader problem. Parts of the economy are clearly improving, particularly export-facing manufacturing, but the domestic recovery remains uneven.

A Reuters poll suggests August exports may have risen 25% from a year earlier, accelerating from 23.9% in July, with the official trade figures due on Tuesday. Strong global demand for technology and AI-related products continues to provide an important external cushion while household spending and investment remain comparatively weak.

Beijing is also reinforcing the financial system. The authorities are injecting roughly $54 billion of capital into major state-owned banks and insurers in an effort to strengthen balance sheets and maintain their capacity to lend. That should improve financial resilience, but capital alone cannot manufacture demand. If households and businesses remain reluctant to borrow and spend, the benefit to the real economy will be limited.

China is therefore leaning more heavily on manufacturing and exports to carry growth. That may work economically in the near term, but it comes with a political cost. The more excess industrial capacity is pushed into overseas markets, the greater the likelihood of further trade friction with the US and Europe.

Risk appetite is holding, but investors are becoming more selective

Equity markets have not broken under the weight of higher oil and bond yields, although there are signs that investors are becoming more defensive.

For the week, the SPX500 lost about 0.07% and the Nasdaq rose 0.12%, while the US30 slipped 0.6%. The EUSTX50 fared worse, losing 1.23% as European markets proved more sensitive to the combination of higher energy costs and tighter monetary-policy expectations.

Fund flows tell a slightly more cautious story. Investors withdrew $11.12 billion from US equity funds in the week to 2 September, marking a second consecutive weekly outflow. Money-market funds, by contrast, attracted $48.76 billion, their largest inflow in four weeks. That is not a wholesale flight from risk, but it does suggest that cash is becoming more attractive as yields rise and uncertainty builds.

The reaction of FXCM's USDOLLAR to Friday's jobs report was also telling. It initially strengthened as Fed rate-rise expectations climbed, but could not hold the move. Part of the reason is that tighter policy is no longer a uniquely American story. The ECB is expected to raise rates this week, while markets are putting roughly a 75% probability on a quarter-point Bank of Japan increase at its 18 September meeting.

The yen has gained more than 2% over the past week as traders increased their BOJ bets and some carry positions were unwound. That deserves attention beyond the currency market. A sustained strengthening of the yen could alter the incentives facing Japanese investors who have accumulated vast holdings of overseas assets during years of ultra-low domestic interest rates.

Gold, meanwhile, has struggled against rising real yields. After falling on Friday, spot bullion slipped further to around $4,403 an ounce earlier today as stronger US employment data increased expectations of higher interest rates.

New Zealand has already moved. The Reserve Bank of New Zealand raised its official cash rate by 25 basis points to 2.75% on 2 September. It said rates may need to rise again if necessary, with policymakers particularly alert to the risk that the oil shock becomes embedded in domestic price-setting behaviour.

What matters next

This is one of those weeks in which a handful of releases could materially change the market narrative.

The ECB decision on Thursday comes first, alongside US producer-price inflation. Friday then brings US CPI, which is likely to have the greatest influence on expectations for the Fed's 15-16 September meeting. A softer core reading would reopen the door to a pause. A hotter number would make the combination of strong employment, resilient services activity and expensive energy increasingly difficult for the Fed to overlook.

Oil deserves just as much attention. The price of UKOil is useful, but diesel prices and actual shipping traffic through Hormuz may tell us more about whether the shock is beginning to spread through the real economy.

Beyond the immediate data, the bigger question is whether the rise in global yields eventually does the central banks' work for them. Housing, corporate financing and equity valuations are all becoming more sensitive to borrowing costs. If those channels begin to weaken materially, policymakers may have less need to push rates much further.

For now, though, that slowdown has not arrived.

Final thought

Markets can live with strong growth, and they can usually live with an energy shock. Living with both at the same time, while borrowing costs are rising across the world, is a much tougher proposition. The bull case still rests on earnings being strong enough to absorb higher discount rates without demand cracking, and on inflation remaining contained enough to stop central banks from tightening too aggressively. Neither condition has failed yet, but the room for error is getting smaller.

References

• reuters.com
• reuters.com
• cmegroup.com
• reuters.com
• reuters.com
• reuters.com
• reuters.com
• reuters.com
• reuters.com
• reuters.com