Navigating Choppy Market Seas
The market (or robots) continues to overreact to data that is, by nature, volatile.
Well, the market is once again flirting with recession discussions. Given only one payroll report really below expectations and closer to 100k, the market already thinks that the Fed's put has returned to the table.
Of course, the data points towards a labor market that's not as hot as it was back in late 2023, but we must be careful not to overreact to a single data point, especially the payroll, which can change frequently in the past. We must remember that April's payroll (108k) was really weak, and the following month basically doubled that level (216k).
The current print (114k) could reflect a clear slowdown in immigration, which has been boosting the headline but now, with the decline in southern border encounters in the last 2-3 months, the best part of the labor supply recovery could be behind us.
More importantly, Hurricane Beryl played a significant role last month. We had the highest jump in layoffs and people out of work due to bad weather in the reference week of the BLS survey for a July report. We must remember that the hurricane impacted Texas and especially Houston, the 4th largest city in the US.
For those trying to estimate the weather impact of Hurricane Beryl on payrolls, it's better to look at what happened during Snowmageddon (2010), the Groundhog Day Blizzard (2011), and Hurricane Irma (2017) events. There's always a clear normalization in the following month, with the payroll headline returning to a healthier level. Even the San Francisco Fed, in its own weather-adjusted payroll, estimated a 'real payroll' of 148k in July, which is pretty good by historical standards.
Does that mean the labor market isn't cooling off and the Fed could ignore the data? Of course not, and they aren't. But on the other hand, I don't see reasons for a 50 bps cut in this sense. We're definitely not on the verge of a recession.
Just to remember, the Private domestic demand growth, a cleaner metric of underlying economic strength, maintained a robust 2.6% in both Q1 and Q2. The carry-over remains pretty good for Q3, and several fundamentals still provide solid arguments for growth to continue above potential in the short term. We've had real wage gains, low unemployment levels, fiscal impulse with government spending like in wartime, clear easing of financial conditions, and now the easing of credit conditions as presented by the Q3 SLOOS survey. More than ever, we have very healthy household balance sheets, with asset prices supporting an increase in wealth (financial and real estate) while the debt part of the equation continues to be low in historical terms, even with an increase in delinquency rates in some components (like credit cards and auto loans).
With that, despite the lag effect of monetary policy and even the exhaustion of excess savings, I do see room for the US economy to deliver a soft landing. That's what models tell me.
On the inflation side, we're in a very good environment, with services disinflation becoming more evident, not only in housing inflation - which is pretty relevant in terms of CPI and PCE weight - but also in components of the supercore. Going forward, the residual seasonality and the lower level of surprises in the second half should reinforce the sentiment that the Fed can deliver the target in 2025. Of course, the goods disinflation won't last forever, especially if import tariffs become higher, but we still have a good trend ahead. The Fed can't take it for granted, given that house prices aren't falling anymore and could slow down the progress in rents inflation in 2025, but the risk balance is more balanced now.
My baseline scenario projects PCE below 2.4% by year-end, with core PCE slightly above 2.6%. I anticipate a gradual approach to the Fed's target, with core PCE much closer to 2% by the end of next year. The 12-month disinflation may slow due to base effects, but we expect progress to become more evident in 2025.
So finally, given the current growth and inflation scenario, I see reasons to start a mid-cycle rate cut adjustment, like in the Greenspan playbook, with at least 5 back-to-back cuts of 25 bps. But there's no strong evidence for several cuts of 50 bps that the market is pricing in.
The FOMC will maintain flexibility in its approach, potentially using the upcoming Jackson Hole symposium to provide further insights into their scenario before the September meeting. We must remember that literally on the day of the August payroll, the Fed will enter its blackout period, so there's a very narrow window for several members to digest the data and give some hints of the policy decision. We'll probably have to keep looking to Timiraos during the following days after the data. Only a payroll below the current print should justify a sharp frontloading of monetary policy and, for now, I'm not on that boat.
Finally, there's this open question: was that a sharp and short-lived sell-off due to CTA activity, especially in August, a month of low volume in markets, or is that a new trend that the market will face, becoming more reactive to negative growth surprises rather than solid prints?