Macro
This week’s economic developments were driven by the August payroll report, which missed expectations for job growth, while the unemployment rate was better than anticipated. The market now treats “bad news as bad news,” with caution reflecting a potential shift. A key issue is that economic slowdowns often start from strong levels, making distinguishing between a soft and hard landing difficult. Early on, job creation and wage growth may appear steady. Still, the labour market can deteriorate rapidly, turning a soft landing into a hard one as consumer spending and confidence falter.
Strong retail sales and PCE growth may appear supportive but are likely lagging indicators, masking a weakening economy. Housing—a key leading indicator—continues to show stress due to rising interest rates and reduced demand, signalling broader economic concerns. Meanwhile, initial jobless claims remain steady, but continuing claims have hovered above 1.8 million, reflecting a slowing ability of the labour market to reabsorb workers.
Globally, China’s economic troubles deepen, with loan growth at all-time lows and the housing market in freefall. This leads to a direct drag on GDP and a negative wealth effect. China’s imploding housing sector, once a growth engine, now weighs heavily on the economy.
In the U.S., the highly anticipated JOLTS report showed job openings dropping to 7.67 million, the lowest since January 2021.
Although hopes remain for a Fed-engineered soft landing, history suggests that rate cuts often coincide with recessions. According to Bloomberg’s forecasts, recession probabilities have dropped to 30%, down from 65% in mid-2023. Nonetheless, ongoing concerns such as a stronger yen and rising shipping costs could ignite supply-side inflation, further complicating the economic outlook.
Next week, we have important inflation data. On Wednesday, we have August core CPI, expected to stay at 0.2% m/m and 3.2% y/y. On Thursday, we have August core PPI, which is expected to rise to 0.2% from 0.0% in July.
Rates
The bond market is currently pricing aggressive rate cuts by the Federal Reserve, anticipating a reduction of around 200 basis points (bps) by the end of 2025. For yields to fall further, the Fed would likely need to cut rates more significantly, typically in response to a recession or sharp economic downturn.
This week, yields slid significantly, with the 2-year yield dropping by 25 bps. The yield curve started to steepen, signalling the end of one of the longest yield curve inversions in history. As the labour market and growth cool, the yield curve is beginning to normalize, and markets are preparing for the Fed’s rate-cutting cycle.
However, over the past 18 months, the bond market has repeatedly gotten ahead of itself, often pricing in more and earlier rate cuts than warranted, only to adjust based on macroeconomic data that has generally surprised to the upside. With the Federal Reserve’s data-dependent guidance, volatility in bond pricing has increased as markets must quickly adjust to new information.
The Fed’s terminal rate is now around 3.25%, and rates are expected to stay above this level unless there’s a substantial economic slowdown or recession. The target rate is expected to be reached by the end of 2025.
Following the latest job market report, the market has nearly eliminated the possibility of a 50 bps rate cut in September, with around 1.2 cuts now expected. For the full year, the market is pricing in over 110 bps of cuts, less than the 130 bps predicted at the beginning of August but more than the end of last week.
With $6.4 trillion now sitting in money markets, investors will soon seek higher returns by extending duration into fixed income. However, the belly of the yield curve remains the sweet spot, as overextending the duration might pose risks. Notably, the 2Y/10Y yield curve turned positive twice this week, ending at 1.5 bps.
Looking ahead, next week’s Treasury auctions include:
- 3-year, $69B on Tuesday, 10/09
- 10-year, $49B on Wednesday, 11/09
- 30-year, $30B on Thursday, 12/09.
Credit
One or two rate cuts will likely ease the pressure on small and medium-sized firms, particularly those reliant on bank loans. However, if interest rates fall back to the 3% to 3.5% range, which is perceived as neutral, it could improve the credit profiles of these companies. The expected 200 bps rate cut by the end of 2025 would considerably lower the interest burden on firms, especially those with substantial bank loan exposure, providing much-needed relief in the current high-rate environment.
While the bond market may be volatile due to sensitivity to macroeconomic changes, companies appear well-prepared to navigate potential economic challenges. Since 2022, corporations have proactively planned for a recession by strengthening their capital structures and building greater resiliency. Companies have fortified their balance sheets in anticipation of a potential economic downturn. As a result, even if the economy slows, the impact on the corporate bond market may be limited. Corporates remain strong with clean balance sheets and can withstand economic pressures. Additionally, many companies are beginning to see the benefits of recent increases in productivity.
This easing cycle would likely reduce many companies’ financial strain due to elevated borrowing costs.
Equities
Equities suffered significant losses this week, with the S&P 500 experiencing its worst week since March 2023 and the Nasdaq’s worst since January 2022. Tech (-7.06%), Energy (-5.63%), and Communication Services (-5.05%) led the declines, while only Consumer Staples (+0.55%) and Real Estate (+0.15%) posted gains.
AI scrutiny, concerns over a slowing consumer, and September’s negative seasonality added to market pressure. Nvidia’s sharp drop in earnings, combined with semiconductor sector weakness, contributed heavily to the market’s decline. Nvidia alone lost 14% of its market value following its earnings announcement, dragging down broader indexes, as it makes up roughly 6% of the S&P 500.
Despite the widespread selloff, some investors might view this weakness as an opportunity to increase exposure ahead of Q4, which was historically the strongest quarter for stocks. However, elevated valuations set a high bar for future earnings growth, creating uncertainty.
Volatility surged, with the VIX rising above 20, reflecting growing market instability. Investors on large cash reserves currently yielding over 4% may be tempted to reenter the market as yields are expected to decline.
The S&P 500 Equally Weighted Index, trading at 18 times earnings, is projected to grow 9.5% this year and 14% next year as rates and capital costs decline. However, questions remain about the sustainability of AI-driven spending and the impact of rising costs on corporate profits.