Strong US data leave the Fed with little reason to hold back

Anyone expecting the US economy to give the Federal Reserve a reason to ease up was disappointed by Friday's employment report. The economy added 165,000 jobs in October, comfortably beating expectations of roughly 65,000. Unemployment edged down to 4.1%, while revisions added another 84,000 jobs to the previous two months. Wage growth also remained firm, with average hourly earnings rising 0.4% in October and 3.1% from a year earlier.

Traders took the hint. The implied probability of a quarter-point increase in December moved from approximately 75% to 80%, which would take the federal funds target range to 4.00–4.25%.

There is more behind this shift than one strong jobs report. October's ISM manufacturing index climbed to 55.5, while services held at a healthy 54.5. More troubling for policymakers were the prices-paid readings of 75.2 in manufacturing and 73.0 in services. Businesses are still facing substantial cost pressures, and the economy appears strong enough for at least some of those increases to reach consumers.

That makes tomorrow's inflation report particularly important. Economists expect consumer prices to rise 0.3% for the month. A softer reading would offer some reassurance, but another upside surprise could leave the Fed with very little justification for standing aside in December.

Europe's inflation problem is becoming harder to manage

The inflation picture across Europe is considerably less comfortable. Eurozone headline inflation reached 4.0% in October, up from 3.8% and its highest reading in three years. Energy prices were the main culprit, rising 20.8%, although services inflation also edged higher to 3.3%. Core inflation remained at 2.5%.

The difficulty is that the European economy is hardly firing on all cylinders. The composite purchasing managers' index slipped from 53.1 to 51.7 in October, pointing to a noticeable loss of momentum. September retail sales were equally discouraging, falling 0.7%, with Germany recording a particularly sharp 2.0% contraction.

For the European Central Bank, this is an awkward combination. Raising rates could help prevent higher energy prices from feeding into wages and broader inflation expectations. Yet tighter borrowing conditions would also weigh on households and businesses at a time when domestic demand is already showing signs of fatigue. The recent retreat in oil prices is welcome, but it has not removed that dilemma.

Across the Channel, the Bank of England has decided that the inflation threat warrants action. Policymakers raised Bank Rate by 25 basis points to 4.00%, the first increase since August 2023. Eight members supported the move, while Catherine Mann argued for a larger, half-point increase. The Bank now expects inflation to approach 5% by the middle of 2027, largely reflecting higher energy costs.

The increase itself was widely anticipated. What caught attention was the direction of the dissent. The only policymaker breaking ranks wanted to move faster, not slower. Another increase in December is certainly possible. Whether the Bank can sustain a longer tightening cycle without doing further damage to growth is a different question.

Wall Street is beginning to question the price of the AI boom

Last week's equity sell-off was a reminder that even the strongest investment themes eventually face a valuation test. The NAS100 declined 4.97%, the SPX500 lost 2.7% and the US30 slipped 0.96%. Semiconductor stocks were particularly hard hit. Meanwhile, the VIX climbed from 19.05 to 25.63, reflecting a marked deterioration in investor confidence. Friday brought some relief, but not enough to undo the damage inflicted earlier in the week.

Two concerns appear to have collided.

The first concerns the enormous sums being committed to artificial intelligence infrastructure. Investors are increasingly asking when those investments will translate into returns substantial enough to justify today's valuations.

The second emerged from the US midterm elections. Democratic victories raised questions about the possibility of tougher regulation affecting AI companies and data centres.

Thursday's 7.13% NAS100 plunge, which wiped approximately $2.5 trillion from market capitalisation, brought those anxieties into sharp focus. It would be premature, however, to conclude that investors are abandoning equities.

Global equity funds attracted $38.6 billion in the week to 4 November. At the same time, money-market funds drew an extraordinary $172.7 billion, their largest weekly inflow since April 2020.

That distinction matters. Money is still finding its way into stocks, but investors are also accumulating cash at a remarkable pace. They appear willing to participate in further gains, provided they retain the flexibility to respond if conditions deteriorate.

The AI investment case is not necessarily broken. What has changed is the market's willingness to accept ambitious growth assumptions without demanding clearer evidence of future profitability.

Government bonds found buyers, although inflation remains a threat

One of the more interesting developments was the behaviour of government bonds. Despite Friday's strong employment figures, the US ten-year Treasury yield finished the week near 4.86%, approximately seven basis points lower. Yields also declined in Germany, Britain and Canada as investors sought protection from equity-market volatility.

There is an important distinction here. Bond yields did not fall simply because investors became more confident that inflation was under control. Much of the demand reflected nervousness about equities and relief from lower oil prices. Indeed, Treasury yields moved higher following Friday's employment surprise.

That leaves the bond rally vulnerable to an uncomfortable inflation reading this week. If consumer prices remain stubbornly high, investors could find themselves confronting the unusual combination of pressure on equities and rising government bond yields.

The dollar, meanwhile, found support in the prospect of tighter US policy. Earlier today, FXCM's USDOLLAR basket was trading near 12,800, with the euro around $1.115 and the yen close to ¥158.2 per dollar. The contrast between resilient US activity and Europe's weaker economic momentum is once again providing support for the greenback. For currency markets, relative economic performance may matter just as much as the next interest-rate decision.

Cheaper oil is offering relief, but the Middle East remains a risk

Oil provided one of the week's more encouraging developments. UKOil ended Friday at $97.88 a barrel, while USOil settled near $90.47. Both benchmarks recorded substantial weekly declines. UKOil weakened further towards $96.90 today after President Donald Trump suggested that renewed attacks on Iran were unlikely while diplomatic negotiations continued to make progress. For an economy struggling with the consequences of expensive energy, that is no small development.

Lower crude prices can ease pressure on household budgets, reduce transport and production costs, and improve the outlook for inflation. They may also give central banks some breathing room after months of difficult decisions. But it would be a mistake to assume that the geopolitical premium has disappeared.

Attacks affecting Gulf shipping routes remain a concern, and the diplomatic outlook is far from settled. A deterioration in negotiations could quickly reverse the recent improvement.

For now, oil has moved from being an immediate source of inflation anxiety towards something of a stabilising influence. Whether that lasts will depend as much on diplomacy as on underlying supply and demand.

Gold also attracted renewed interest. The metal recovered approximately 5% over the week to around $4,065 an ounce, supported by falling bond yields and growing demand for defensive assets.

Its strength alongside a firmer dollar is revealing. Investors appear more concerned with protecting portfolios against volatility than positioning for a simple shift towards easier monetary policy.

China's inflation figures tell two very different stories

China's latest price data highlight another difficulty facing the global economy. Higher production costs do not necessarily translate into stronger pricing power. Producer prices rose 5.7% in October from a year earlier, accelerating from 5.0% and exceeding forecasts of 5.3%. Higher energy costs were an important contributor. Consumer inflation told a different story, easing to 0.7%, while core inflation slowed to 0.8%.

The implication for Chinese businesses is straightforward, and hardly encouraging. Manufacturers are paying more for inputs, but subdued household spending is making it difficult to pass those costs on to customers. Unless domestic demand improves, profit margins could come under increasing pressure.
It also raises a broader policy question. China has spent years supporting industrial capacity. The latest figures strengthen the argument that restoring household confidence and consumption may now be the more pressing priority.

The week ahead

Tuesday's US consumer inflation report is the obvious centrepiece, with producer-price figures following on Friday. Both releases will influence expectations for December's Federal Reserve meeting and could determine whether last week's bond rally has further room to run.

Elsewhere, revised eurozone GDP figures and employment data should provide a clearer picture of Europe's slowdown. Chinese credit numbers, developments in Middle East diplomacy and another round of AI-related corporate earnings will also deserve attention.

The question running through all of these developments is whether falling energy prices can provide enough inflation relief to offset the strength of the US economy. If they can, bonds may find more lasting support and central banks could gain some welcome flexibility. If they cannot, investors may face the rather less comfortable environment of higher interest rates just as enthusiasm for expensive growth stocks begins to cool.

Final thought

Cheaper oil has given markets some breathing room, but with the US economy still running strongly and investors questioning the price of the AI boom, there is little room left for either inflation or corporate earnings to disappoint.

References and sources

• bls.gov
• ismworld.org
• ec.europa.eu
• reuters.com
• bankofengland.co.uk
• reuters.com
• reuters.com
• uk.marketscreener.com