The benign slowdown narrative has come under pressure

The market's comfortable slowdown narrative was tested last week. Softer US employment, retail-sales and inflation data had encouraged expectations that the Federal Reserve could remain on hold for longer. August business surveys complicated that picture, showing activity running materially stronger than expected.

The US services PMI rose from 54.6 to 56.8, its highest level since December 2024, instead of slipping to the expected 54.0. The composite PMI reached a four-year high of 56.0, a pace consistent with annualised third-quarter growth approaching 3%, compared with 1.5% in the second quarter. Manufacturing growth slowed, however, as weaker inventory building and disruption from the Iran conflict weighed on production. The broader message is that the US economy looks stronger than recent retail-sales data suggested, although that resilience is becoming increasingly reliant on services and household demand.

The Federal Reserve's July minutes reinforced the more hawkish interpretation. Several policymakers were prepared to raise rates immediately, three voted for a quarter-point increase and many thought tighter policy would eventually be necessary unless inflation moved convincingly towards 2%. Markets now assign roughly a 40% probability to a September increase and fully price a move by December, up from around 30% at the start of last week.

This week's core PCE inflation release and Chair Kevin Warsh's Jackson Hole address will therefore be important in determining whether stronger growth is interpreted as welcome resilience or as a sign that policy is still not restrictive enough.

Bond markets are challenging fiscal policy

Long-term sovereign yields reached multi-year to multi-decade highs across the US, Japan and Europe. The US 30-year yield briefly touched 5.34%, its highest since 2007, while the ten-year approached 4.73%. Japan's ten-year yield moved towards 3%, Germany's reached its highest level since 2011 and Britain's 30-year borrowing cost remained close to levels last seen in 1998.

The sell-off reflects more than inflation. Investors are demanding greater compensation for financing heavy government deficits at the same time that technology companies are issuing growing amounts of debt to fund AI infrastructure. The US Treasury's unexpected decision to double buybacks of longer-dated Treasury securities to at least $4 billion per operation briefly pushed yields lower, but the relief did not last. The programme may improve market liquidity, but it does nothing to reduce the government's underlying borrowing requirement.

That distinction matters. Higher long-term yields feed directly into mortgage and corporate financing costs while also lowering the present value investors are willing to place on future earnings. For markets, the long end of the curve is increasingly becoming a more important restraint on financial conditions than the Fed's next quarter-point decision.

Growth signals are diverging internationally

Eurozone activity provided another upside surprise. The composite PMI rose to 52.1, manufacturing reached a four-year high and export orders expanded for the first time since February 2022. Input and selling-price pressures eased, but headline inflation remains at 2.9% and oil has moved back above $90. Economists expect the European Central Bank to raise rates by 25 basis points in September, meaning stronger growth has weakened the case for delaying further tightening

Britain showed a similar, if less dramatic, pattern. The services PMI rose more than expected to 52.8, while July inflation increased from 2.6% to 2.9%. The Bank of England is still expected to hold rates at 3.75% for the remainder of the year, but resilient activity and renewed price pressure helped sterling to a fourth consecutive weekly advance, alongside broader weakness in the dollar.

Japan's core inflation accelerated to 1.8% in July, strengthening expectations that the Bank of Japan will raise its policy rate from 1% to 1.25% in September. Rising Japanese yields are also beginning to offer domestic investors a more credible alternative to overseas markets, potentially reducing an important source of demand for US Treasuries and other foreign bonds.

China remains the clear exception. Industrial production slowed to 4.5% in July, retail sales rose only 0.6% and fixed-asset investment contracted 6.7% during the first seven months of the year. Each result missed expectations. Exports linked to global AI demand continue to provide some support, but weak consumption, property activity and investment suggest that China's domestic economy is losing momentum.

Risk appetite is becoming more fragile

The SPX500 fell 1.4% last week, the Nasdaq lost 2.4% and the US30 declined 0.84%, ending three consecutive weekly gains for both the S&P 500 and Nasdaq. Higher yields hit long-duration technology shares particularly hard, with the semiconductor index falling 5% on Tuesday.

Nvidia's results on Wednesday now represent an unusually concentrated test of the equity rally. Consensus expects quarterly revenue to almost double to roughly $92 billion. The real risk is not simply an earnings miss. Investors will be looking for any indication that the extraordinary sums being committed to AI infrastructure are beginning to generate returns that justify the scale of the spending.

Oil added another source of pressure. UKOil gained 6.3% last week to settle at $94.04, while WTI rose 5.4% to $86.81. AIS-detected traffic through the Strait of Hormuz remained roughly 90% below pre-conflict levels in the week to 21 August, while fewer than 20 commodity vessels were detected crossing the waterway over the weekend. Prospective US sanctions against Iran's trading partners add another layer of uncertainty to an already constrained supply backdrop.

FXCM's USDOLLAR nevertheless fell about 0.5% as concerns over US debt and policy credibility outweighed the support normally provided by rising yields. The euro gained roughly 0.9%, while gold advanced to about $4,650 an ounce ontoday and is up around 15% in August. The combination of weaker Treasuries, a softer dollar and stronger gold is unusual. Rather than looking like a conventional flight to safety, it suggests investors are becoming more uneasy about the cost and credibility of financing the US fiscal position.

Final thought

Markets are no longer confronting a simple inflation problem, but a collision between resilient growth, constrained energy supply, immense borrowing requirements and demanding equity valuations just as the cost of capital is rising.

References

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