The central macro shift

The past week weakened the case for a September Federal Reserve rate increase without removing the underlying inflation risk. US headline CPI rose by 0.1% in July and eased from 3.5% to 3.4% year on year, while core inflation slowed from 2.6% to 2.5%. Headline producer prices were unchanged, against expectations for a 0.2% increase, although the measure excluding food, energy and trade services rose by a firmer 0.4%. Markets reduced the implied probability of a September increase from roughly 50% before the latest run of data to around 30%.

The growth data made patience easier for the Fed. US retail sales fell by 0.6% in July, their first decline in nine months, compared with expectations for a 0.1% increase. The retail control group, an important input into estimates of goods consumption in GDP, declined by 0.4% rather than rising by the expected 0.3%. Preliminary consumer sentiment fell from 55.2 in July to 51.0 in August, while households' one-year inflation expectations edged up from 4.2% to 4.3%. The figures point to a loss of consumer momentum, although lower petrol prices, Amazon's decision to hold Prime Day in June and fading tax-refund effects also depressed July's comparison.

The important distinction is between near-term monetary policy and structural borrowing costs. Short-dated Treasury yields declined after the softer data, but longer-dated yields remained elevated. The real yield on 30-year inflation-protected Treasuries moved above 3% during the week, reaching its highest level since 2008. Heavy government borrowing and elevated bond supply are increasing concern about the availability and cost of long-term capital, while the scale of AI-related investment could add to competition for funding. The Fed may remain on hold, but long-duration assets are receiving less relief because fiscal and supply pressures remain unresolved.

Growth is becoming less synchronised

Japan's economy expanded at an annualised rate of 1.1% in the second quarter, below the 2.0% consensus forecast, as household spending and business investment weakened. The ten-year Japanese government bond yield nevertheless reached approximately 2.93%, a nearly 30-year high, as markets confronted inflation pressure from elevated energy costs and a weak yen alongside expansionary fiscal policy. Against this background, the Bank of Japan faces softer domestic demand and mounting inflation pressure, with policymakers considering another rate increase as soon as September.

Europe's economy has proved more resilient. Eurozone GDP grew by 0.4% in the second quarter after stagnating in the first, while Britain also expanded by 0.4% and was on course to record the fastest first-half growth in the G7. Renewed energy-price pressure could nevertheless reduce the room for either the European Central Bank or the Bank of England to support growth aggressively. Europe's relative economic improvement is constructive, but remains vulnerable to a sustained oil shock.

China continues to present the weakest demand signal. New yuan bank lending contracted by a record 340 billion yuan in July, while household loans fell by 460.3 billion yuan. Seasonal effects following June's quarter-end lending push contributed to the decline, but the figures still suggest that lower borrowing costs alone are not restoring household confidence or private-sector credit demand. China's July activity figures will be judged primarily for evidence that domestic demand is becoming strong enough to reduce the economy's reliance on exports.

Markets remain bullish but increasingly selective

The SPX500 reached a record closing high during the week and gained 0.4%, while the NAS100 advanced by 1.15%. Both indices recorded a third consecutive weekly increase. Strong earnings remain an important source of support, but Applied Materials' 5.1% decline despite an upbeat forecast showed that positive results may not be sufficient when investor expectations are already elevated. The SPX500 trades at approximately 20 times expected earnings, leaving less room for disappointment in AI-related revenue, earnings or capital-spending assumptions.

European equities slipped by 0.3%, ending a four-week advance, although the STOXX 600 finished within approximately 1% of its record. Aggregate second-quarter earnings are forecast to grow by 23.4%, the strongest increase in nearly four years, led by energy and materials companies. Risk appetite therefore remains intact, while energy-led earnings and Europe's lower technology weighting are giving investors an alternative to highly valued US technology shares.

Oil remains the clearest immediate macroeconomic threat. UKOil rose by 7.5% last week to settle at $88.46 a barrel, while USOil gained 6.7% to $82.34. Tanker attacks, sharply reduced traffic through the Strait of Hormuz and stalled US-Iran negotiations restored part of the geopolitical risk premium. A sharp increase in US crude inventories and softer global demand-growth forecasts provide some counterweight, but a prolonged disruption would affect inflation, household spending and central-bank policy simultaneously.

Reduced expectations of a September Fed increase helped push the dollar index towards its monthly low. The EURUSD reached a two-month high near $1.160, while XAUUSD rose this morning to $4,406 an ounce. These moves reflect reduced US policy-rate expectations and a weaker dollar, while gold continues to benefit from geopolitical uncertainty and safe-haven demand.

What matters next

The key tests are whether August business surveys confirm a broader US slowdown, whether the Federal Reserve's meeting minutes support the market's reduced expectations of a September rate increase and whether disruption through the Strait of Hormuz persists. Results from Home Depot, Target and Walmart will also help determine whether July's weaker retail data were a temporary reversal or the beginning of a more durable consumer slowdown.

Final thought

Markets are taking comfort from the reduced risk of a September Fed increase, but rising oil prices, weaker consumer momentum and persistently high long-term yields mean that the relief is clearest at the front of the bond market rather than extending cleanly across richly valued risk assets.

References

reuters.com