Economic data validate Fed’s plans

The string of indicators published last week in the US highlights a robust, even dynamic, expansion. The much-anticipated employment report showed a marked rebound in job creation in September, with 254,000 jobs created after 159,000 in August, a figure that was revised upwards. The unemployment rate derived from the household survey fell further to 4.1%. The jump to 4.3% that had alarmed the financial markets at the beginning of August is now seen as a temporary anomaly.

The sustained rise in average hourly earnings (0.4% month-on-month, 4.0% year-on-year), now well in excess of inflation, should have a favourable impact on consumer spending. Other statistics relating to the labour market corroborate the message conveyed by the employment report. The number of job vacancies rose sharply in August, and initial jobless claims remain at a low level. The ISM surveys show persistent sluggishness in the manufacturing sector, reflected by an unchanged PMI of 47.2 in September, and a significant strengthening in business activity in the services sector, where the PMI jumped from 51.5 in August to 54.9 in September.

The recent news validates the ‘gradual’ roadmap unveiled by central bankers at the last FOMC meeting and reaffirmed by Jerome Powell in his speech on 30 September. The path involving two further cuts of 0.25% between now and the end of the year remains realistic, but investors have been forced to revise down their expectations of a faster and more generous interest rate cut. As a result, the week ended with a sharp rebound across the entire interest rate term structure. The pain was particularly severe on short maturities, with the yield on 2-year Treasury bonds jumping by more than 40 basis points to break the 4% barrier, which was also exceeded by the yield on 10-year T-Notes.

The rebound in dollar yields was felt in Europe, with the notable exception of Switzerland, which was largely spared. After flirting with a level of 2%, the yield on the 10-year German Bund climbed back to around 2.25%, without the slightest regard for the fall in inflation seen in September. Down by 0.1% in September, the consumer price index for the eurozone showed an annual rise of 1.8%. Excluding energy and food, ‘underlying’ inflation was 0.1% over one month and 2.7% year-on-year. Although the eurozone is stagnating, an unemployment rate unchanged at 6.4% still reflects a tight labour market by historical standards. Despite this, the deterioration in the business climate and the fall in inflation justify a further cut in interest rates next week and then in December, taking the deposit rate to 3.0% by the end of the year.

The rebound in oil prices resulting from escalating tensions in the Middle East and the ambitious stimulus package announced in China have also undermined bonds. Despite this, the recent correction is creating new opportunities for investors overexposed to equities with complacent valuations or money market investments bound to become less profitable.