Markets rally as Powell hints at September rate cut

Markets

Fed Chair Powell ignited a bond and stock market rally last Friday by saying in his key Jackson Hole speech that downside risks to employment are rising. “With policy in restrictive territory, the baseline outlook and the shifting balance may warrant adjusting our policy stance.” The Fed chair gives the nod for a cautious September rate cut (25 bps). His tone was more subtle than last year around when Powell’s “the time has come for policy to adjust” and “the direction of travel is clear” resulted in a 50 bps opening rate cut and a cumulative effort of 100 bps in Q4 2024. Powell’s main arguments echo the ones put forward by one of the two dissenters at the July FOMC meeting, Waller. The Fed chair is puzzled by the curious state of the US labour market: low in demand and low in supply, keeping the unemployment rate stable. Once firms shift from labour hoarding to lay‐offs, the labour market could deteriorate quickly. If this assumption of underlying weakness is correct, Powell argues that second‐round inflation effects coming from higher US tariffs can be avoided as employees are not in the position to demand for compensating higher wages. Tariffs would in such scenario effectively result in a one‐off increase in prices instead of creating lasting inflationary pressures. Powell in his final Jackson Hole appearance also shared conclusions from the central bank’s monetary policy framework review. First, the Fed reviewed language indicating that the effective lower bound (0%) was a defining feature of the economic landscape. Second, the Fed switched back to a flexible inflation target instead of the average inflation targeting strategy, allowing for longer deviations from the 2% target to “make up” for periods of deviations at the other side of the 2%. In the current set‐up, this suggests a slightly more restrictive monetary policy in the longer run. Other smaller changes included a clarification to the Fed’s reaction function when the ideal response is not complementary with the employment and inflation objectives. That’s the situation the US central bank is in right now. The Fed will then take into account the extent of departures from its goals and the potentially different time horizons over which each is projected to return to a level consistent with the dual mandate.

The US yield curve bull steepened with yields dropping by 4.2 bps (30‐yr) to 10.1 bps (3‐yr) to Powell’s pivot. The implied probability of a September rate cut increased from around 70% to 85%. Disappointing US labour market data or absence of more pronounced inflationary pressures can still move the needle on US money markets for the remainder of the year with the base scenario currently being a skip in October and another 25 bps rate cut in December. US Treasuries obviously outperformed German Bunds. Changes on the German curve range between           ‐1.8 bps (30‐yr) and ‐3.8 bps (5‐yr). Loss of interest rates support propelled EUR/USD from 1.1606 to 1.1718, but still withing this summer’s trading range (1.1392‐1.1829). The current set‐up increases the probability of a topside test. US stock markets rallied 1.5% to 1.9% last Friday, making up for lost ground earlier that week. Today’s eco calendar is thin with German Ifo business sentiment and a Belgian OLO auction the only things to watch. Trading volumes will be low during European trading hours with UK markets closed (Summer Bank Holiday).

News and views

Canadian PM Carney on Friday announced that his government will remove retaliatory import tariffs on US goods that are covered under the US‐Mexico‐Canada free trade agreement (USMCA). The move came as the US recently also indicated that it didn’t intend to impose tariffs on goods that were compliant with the USMCA. In this respect, Cananda from September 1st will no longer impose a 25% tax on many US consumer products. At the same time, Cananda will maintain a 25% import tax on US steel and aluminum products as well as on US cars and trucks. The milder approach of the Canadian government comes as both countries will start preparations on a new trade agreement as the USMCA trade deal will come up for review next year. Carney also indicated "Canada and the U.S. have now re‐established free trade for the vast majority of our goods," and said that Canadian exports overall are still subject to a low level of US tariffs, compared with other trading partners.  

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