Markets have moved closer to another Fed rate rise

The biggest change over the past few days has come from the Federal Reserve. Chair Kevin Warsh used his Jackson Hole speech to turn a long-standing concern about inflation into a much clearer warning on policy. His argument was straightforward: inflation is still above target, employment remains relatively stable and financial conditions are difficult to describe as particularly restrictive. Unless the Fed gains greater confidence that inflation is heading back towards 2%, it may still have work to do.

Markets took the message seriously. The implied probability of a September rate increase rose from roughly 35% before the speech to around 60%, while the two-year Treasury yield jumped about 13 basis points on Friday to 4.36%. The ten-year yield climbed to around 4.73%. Barclays has also changed its call and now expects quarter-point increases in both September and December.

The economic data gave investors little reason to dismiss Warsh's warning. July headline PCE inflation remained at 3.7%, slightly above the 3.6% expected, while core PCE held at 3.3%. Real consumer spending was essentially unchanged during the month, suggesting households have lost some momentum. But beneath that softer headline, the economy still looks reasonably firm. Second-quarter consumption growth was revised up from 3.2% to 3.4%, while final sales to private domestic purchasers, a useful measure of underlying private-sector demand, grew at a 4.2% annualised rate. Corporate profits also rose sharply during the quarter.

That leaves the Fed with an uncomfortable mix rather than a genuinely stagflationary one. Consumers appear to have taken a breather in July, but investment, profits and underlying demand remain too resilient for policymakers to be confident that inflation will simply fade away without further restraint. A September increase is therefore now the market's marginal base case.

AI earnings are still supporting equity risk

Nvidia once again cleared an unusually high bar. Quarterly revenue more than doubled to $96.2 billion, comfortably ahead of the $92.2 billion consensus estimate, while its $108 billion forecast for the current quarter also beat expectations. Perhaps more striking was management's decision to look much further ahead, projecting roughly 70% revenue growth for the fiscal year ending January 2028. Before the results, analysts had been expecting growth of roughly 44%.

The message for markets is difficult to ignore. Demand for AI infrastructure does not yet appear to have peaked. Nvidia's results instead suggest that the build-out still has considerable momentum behind it, although that does not mean the path will be smooth. Memory shortages, rising component costs and uncertainty over Chinese sales remain real constraints.

That distinction is becoming increasingly important. The question is no longer simply whether companies want more AI capacity - clearly they do. It is how much that capacity will cost to build, how it will be financed and whether the eventual returns justify the extraordinary level of investment now taking place.

US equities consequently managed to preserve modest gains for the week despite Friday's hawkish reversal. The SPX500 gained 0.52%, the NAS100 0.48% and the US30 0.51%. Friday itself told a less comfortable story. Declining stocks outnumbered advancers by more than two to one on the Nasdaq, while Nvidia fell 4.6% as the jump in bond yields overwhelmed some of the enthusiasm surrounding its results.

Risk appetite is still intact, in other words, but the market is asking earnings growth to do increasingly heavy lifting as the discount rate moves against it.

Oil has restored the geopolitical inflation premium

Oil remains the other major complication. UKOil ended Friday at $88.19 a barrel, recording its first weekly decline in three weeks as traders reacted to rumours of a possible agreement on shipping through the Strait of Hormuz. Negotiations and diplomatic efforts have continued, but no durable reopening agreement has yet been secured.

The relief did not last long. UKOil rebounded by more than 1.8% to above $90 early today after US forces struck Iranian launchers on Larak Island and Iran retaliated against US bases in Jordan. UK Maritime Trade Operations also reported that a tanker had been struck by a projectile while sailing into the Strait of Hormuz.

For markets, the importance goes well beyond whether oil moves one or two dollars on a particular day. If UKOil settles around $90 or moves materially higher, it becomes much harder for central banks to look through the inflationary consequences. Higher energy prices squeeze household purchasing power, raise business costs and strengthen the case for keeping monetary policy tight. Increasingly, markets are treating every diplomatic headline from the Gulf almost like an inflation release.

Europe and Japan face their own tightening pressures

The pressure is not confined to the US. Eurozone manufacturing has improved noticeably, with the August manufacturing PMI rising unexpectedly to 52.8, its highest level in more than four years. At the same time, July inflation was running at 2.9%. ECB policymakers have left the door open to further tightening and markets are heavily positioned for another quarter-point increase when the Governing Council concludes its next monetary-policy meeting on 10 September.

This week's inflation numbers will therefore carry unusual weight. Another uncomfortable reading would make the September decision relatively straightforward and shift attention towards whether the ECB has more tightening to do afterwards.

Japan is dealing with a different version of the same problem. The yen weakened beyond ¥160 to the dollar despite July's joint Japanese-US intervention, while Japanese government bond yields have continued to rise. The ten-year yield has returned to levels last seen in 1996. US Treasury Secretary Scott Bessent has described the latest currency moves as relatively contained rather than disorderly, reducing expectations of another immediate intervention.

That puts more of the burden back onto monetary policy. Markets currently imply roughly a 70% chance of the Bank of Japan raising rates when it meets on 18 September, with a potentially faster tightening cycle thereafter.

FXCM's USDOLLAR also benefited from Warsh's message, rising around 0.3% on Friday, while spot gold fell 3.12% as Treasury yields climbed. For the moment, tighter policy expectations have proved more powerful than the demand for traditional geopolitical protection.

China's improvement remains narrowly based

China provided a small piece of better news today, although the underlying picture remains uneven. The official manufacturing PMI rose from 49.2 in July to 49.8 in August, ahead of the 49.5 consensus forecast. It remains below the 50 level separating expansion from contraction, but both production and new orders returned to growth. High-technology and equipment manufacturing were among the stronger areas.

The services side tells a much less encouraging story. The non-manufacturing PMI remained at 49.0, its weakest reading since December 2022. Property remains under pressure, fixed investment is weak and domestic consumption has yet to generate enough momentum to drive a broad recovery.

That divergence probably matters more than the improvement in the headline manufacturing number. China is benefiting from AI-related exports and stronger high-tech manufacturing, but its domestic economy remains subdued. Without a meaningful improvement in household demand or a stronger policy response, China is likely to continue supplying a great deal to the world economy while providing relatively little additional consumer demand in return.

What matters next

The next major test comes from Friday's US payroll report. Consensus expects roughly 58,000 jobs to have been added in August, with unemployment holding at 4.1%. July payroll employment declined by 23,000. The August Employment Situation report is scheduled for release on Friday. Given how sharply expectations shifted after Jackson Hole, the report has the potential to move markets disproportionately. A genuinely weak labour number would give the Fed a reason to hold back. Something around consensus, or stronger, would leave a September rate rise very much alive.

Eurozone inflation is the other major macro release to watch, while the Reserve Bank of New Zealand is expected to raise rates again this week. The RBNZ's current official cash rate is 2.50%, with its next decision scheduled for Wednesday. Looming over all of it is the Strait of Hormuz. Oil back above $90 means another serious escalation would quickly feed into inflation expectations, bond yields and the outlook for central-bank policy.

Final thought

Strong profits and exceptional AI demand are keeping the bull market alive, but the backdrop is becoming less forgiving. Inflation remains sticky, oil is volatile and central banks are showing less patience. For equities to keep moving higher, earnings will increasingly have to outrun both geopolitics and a rising cost of capital.

References

• https://www.federalreserve.gov/
• https://www.reuters.com/
• https://www.bea.gov/
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• https://www.reuters.com/
• https://www.reuters.com/
• https://www.reuters.com/
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