The recent inversion of the US yield curve has generated renewed angst about the health of the US economy. Our view on this is unchanged from the comments we provided in the July edition of Quarterly Strategic Outlook; quantitative easing has collapsed the term premium, which is artificially suppressing longer dated bond yields and artificially flattening the yield curve. We think the US economy is fundamentally sound. However, there are risks and we are not completely dismissing the messages from the bond market.
Latest data out of the US supports the story that the trade war with China is having a negative impact on trade and the goods-producing sectors of the economy, while at the same time the tight labour market that is generating albeit modest wage growth is underpinning solid household consumption.
Industrial production fell -0.2% in July while manufacturing production fell -0.4%. For manufacturing, the July contraction represents the fifth decline out of the last seven months with annual rate of growth now at -0.5%. Broader industrial production is posting modest growth of 0.5% for the year, assisted by strength in some domestic activities such as utilities production.
At the same time, retail sales posted broad gains in July, rising 0.7% in the month. The narrower ‘control group’ that more closely resembles the personal consumption expenditure (PCE) measure in GDP posted 1.0% growth in the month. PCE expanded at a rampant 4.3% annualised pace in the second quarter (Q2), strength we don’t expect to see repeated in Q3. That said, the quarter is off to a strong start, supporting current expectations of GDP coming in at around an annualised 2% in the three months to September.
Meanwhile, consumer prices seem to be ticking higher. Core CPI inflation rose 0.3% in July, the second consecutive month of increases of this magnitude. However, at least some of this is due to pass-through from higher tariffs and some is also likely payback from prior months of soft out-turns.
The key takeout from that is the Federal Open Market Committee (FOMC) is unlikely to get too excited by the recent increases and won’t be taking them as a sign of the sort of inflation they are looking for – generalised inflationary pressure emanating from excess demand.
The Committee will also keep a keen eye on clouds on the horizon. In particular, the trade war continues apace, with the risk that weakness in goods-producing sectors becomes a broader economic malaise. Consumer confidence is already softer, indeed the next wave of tariff increases have consumer goods firmly in their sights.
So while inflation has firmed, we expect the FOMC will remain focused on the risks and take out further insurance with a second 0.25% interest rate cut in September.
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