„There’s No Bad Weather, There’s Only Bad Clothing”

By Bas van Geffen, CFA, Senior Macro Strategist at Rabobank

Calm finally appears to be returning. The Japanese Nikkei 225 is up some 10% on the day. That still doesn’t make whole the -12.4% loss from Monday’s session, but at least it takes some of the ‘panic’ out of the selling. Japanese data were much better than expected, and appear to vindicate the Bank of Japan’s decision to adopt a more hawkish stance last week. Additionally, the turnaround may be induced by reports of a three-way meeting between the Bank of Japan, the Ministry of Finance, and the Financial Services agency to “discuss international markets.”

Although the extent of the decline in Japanese markets stood out like a sore thumb, red figures were a theme across the globe yesterday. On Friday market action largely seemed driven by weak US data, but yesterday it evolved into more of a risk-off driven move as investors rebalanced their portfolios. The S&P 500 lost some 4.8% across Friday and Monday, and the EuroStoxx 600 was down a cumulative 4.9%.

But both indices had deeper intraday lows yesterday, which – of course – prompted for urgent calls of emergency rate cuts. Or, failing that, outsized cuts at the remaining scheduled meetings for the year. Because market economy, I guess.

A mild recession, or at the very least a slowdown in growth, was always to be expected if central banks were to get inflation back under control. Is it really up to the Fed to rescue markets again?

The Fed’s Goolsbee was scheduled to appear on a CNBC interview, and used his slot to remind traders that this selloff occurred after a July employment report that makes for just one datapoint: “the central bank’s job is not to react to one month of weaker labour data,” adding that the error margin around the non-farm payrolls estimate is as high as 100,000 jobs.

None of what Goolsbee said sounds like the Fed is actually inclined to make emergency cuts, or even go beyond the usual 25bp rate cut in September: “As you see jobs numbers come in weaker than expected but not looking yet like recession, I do think you want to be forward looking of where the economy is headed for making the decisions.” In other words, the Chicago Fed President still believes the best path is a gradual easing of the currently restrictive policy stance. “The Fed’s job is very straightforward: maximize employment, stabilize prices, and maintain financial stability. If the conditions collectively start coming in that there’s deterioration on any of those three parts, we’re going to fix it. There’s no bad weather, there’s only bad clothing.”

Collectively is the key word here. Because, while the market is now focusing on some signs of weakness in the labour market, yesterday’s ISM survey took some sting out of Friday’s non-farm payrolls. Moreover, the purchasing managers’ survey reiterated that inflationary risks haven’t suddenly disappeared over the past few sessions.

The ISM services index rebounded from 48.8 to 51.4. This ISM survey has been volatile in recent months, and it does not indicate strong growth, but it also does not suggest that the US economy is about to take a nosedive off a cliff. The survey’s employment index rose to 51.1. That’s the highest level since September. Furthermore, the prices paid index re-accelerated to a level that is more in line with the average over the past year.

Likewise, PMI survey for the Eurozone signalled an acceleration of input cost inflation across the euro area. Faster increases in operating expenses were seen at both manufacturers and service providers, although the latter continued to experience the sharpest pressures. The overall pace of input price inflation was the joint-quickest in 14 months (level with April and February). Especially the German services sector reported significant wage cost pressures, but French firms also “often linked higher operating expenses to salary increases.”

At least for July, these costs seem to be absorbed in margins, with output charges rising less rapidly. However, would any central bank really want to cut 50 basis points in September, given these lingering risks? Goolsbee may have listed “financial stability” as another key part of the Fed’s mandate, but stability does not mean that equities can only go up.

Yet, several shops called for 50bp cuts from the Fed at the September and November meetings. The market traded in line with this for most of yesterday, to an extent that the 2s10s Treasury spread even un-inverted. But rate cut bets have lessened since then, and the market is now priced for ‘only’ one 50bp cut in September, followed by 25bp cuts at the other two remaining meetings of the year – although Fed funds futures still price significant downside risks to the fed funds path.