Markets received some of the news they had been waiting for this week.
Inflation moderated.
Producer prices surprised on the softer side. Expectations for an immediate Federal Reserve rate increase declined. Treasury yields eased from recent highs, while the S&P 500 moved to another record.
At first sight, this looks like an increasingly comfortable environment for risk assets. But the underlying message is more complicated. The question facing investors is beginning to change. For much of the year, markets were asking whether inflation would force central banks to tighten policy further. Now another question is becoming increasingly important:
What if inflation is cooling partly because economic momentum is weakening?
That distinction could define the next phase for equities, bonds, currencies and commodities.
Inflation is moving in the right direction
The July US Consumer Price Index increased only 0.1% from the previous month, while annual inflation slowed to 3.4% from 3.5%. Core CPI increased 0.2% monthly and eased to 2.5% annually. Energy prices fell 1.5% during July, providing important relief to the headline number.
Producer prices provided another encouraging signal.
The Producer Price Index was unchanged in July, while prices for final-demand goods declined 0.7%. Energy prices at the producer level fell 3.1%, helping reduce some of the immediate concern that inflation was accelerating again. That was enough for markets to reconsider the urgency of another Federal Reserve rate increase. By Friday morning, traders were assigning only around a 35% probability to a September Fed hike, compared with roughly 55% one week earlier. The next FOMC meeting takes place on September 15–16.
That change in expectations has supported equities. The S&P 500 closed Thursday at a new record of 7,798.99, while the Nasdaq also advanced as investors welcomed the possibility that monetary policy may not need to become significantly more restrictive. But investors should be careful not to confuse better inflation data with the disappearance of inflation risk.
The inflation problem has improved but has not disappeared
Headline inflation of 3.4% is still materially above the Federal Reserve’s objective. There are also details beneath the PPI headline that deserve attention. Producer prices excluding food, energy and trade services increased 0.4% in July and were 4.7% higher than a year earlier. Services prices also increased during the month.
More importantly, energy remains unusually dependent on geopolitics. Brent crude was trading close to $87 per barrel on Friday as continuing tensions involving Iran and the Strait of Hormuz competed with weaker global demand expectations. Oil was still approximately 4% higher for the week despite Thursday’s decline.
That creates a difficult environment for monetary policy. A renewed rise in oil could quickly reintroduce inflation pressure even while other areas of the economy are slowing.
The Federal Reserve therefore does not have the luxury of looking at inflation alone.
The labour market is becoming increasingly important
Last Friday’s employment report changed the discussion considerably. US nonfarm payroll employment declined by 23,000 in July. More importantly, employment growth for May and June was revised lower by a combined 103,000 jobs.
The unemployment rate remained relatively low at 4.1%, but labour-force participation stood at only 61.4% and has declined by 0.7 percentage point since January. Average hourly earnings increased 3.2% from a year earlier.
Markets initially welcomed the weak employment report because it reduced the probability of additional monetary tightening. But investors should distinguish between weak data that reduces interest-rate pressure and weak data that eventually reduces earnings, consumption and investment. They are not the same thing.
There is a point at which weaker economic data stops being positive for equities.
Determining where that point lies may become one of the most important trading questions during the coming weeks.
The consumer is now the next test
That is why Friday’s US retail sales data deserves particular attention. The labour market has weakened. Inflation has moderated. The next question is whether household demand can remain sufficiently strong to prevent the slowdown from becoming more serious.
If consumption remains resilient while inflation continues to fall, markets could begin to price something close to the ideal scenario: moderate growth, easing inflation and no immediate requirement for further monetary tightening.
But if consumption weakens sharply, the interpretation changes.
Lower inflation would then become less clearly bullish because investors would have to consider whether disinflation is increasingly being produced by weakening demand.
For equity investors, that would shift attention from interest-rate multiples toward earnings expectations.
For bond investors, growth concerns could begin to compete more strongly with inflation and fiscal risks.
And for currency traders, the reaction could become much more complicated than simply weak US data equals weak dollar.
The bond market is still refusing to declare victory
This is particularly important because long-term Treasury yields remain high.
The US 10-year Treasury yield is still around 4.7%, even after this week’s softer inflation data reduced expectations for another near-term Fed increase. That matters.
If investors truly believed that inflation had been defeated and monetary conditions were about to become significantly easier, long-term yields would probably be sending a much more comfortable signal. Instead, the bond market continues to price a combination of inflation uncertainty, fiscal risk, geopolitical uncertainty and substantial borrowing requirements.
Equity investors therefore face an unusual combination:
record stock prices alongside historically demanding long-term financing conditions.
That divergence should not be ignored.
Currency traders should watch the YEN carefully
The foreign-exchange market provides another example of why the environment cannot be reduced to a simple Federal Reserve story.
The Japanese yen has weakened again toward 160 per dollar despite previous intervention, trading around 159.4 on Friday morning. Traders increasingly view 160 as a level at which renewed official action becomes possible. At the same time, expectations for another Bank of Japan rate increase have increased. This means USD/JPY is becoming a particularly interesting expression of competing forces: US yields, Japanese monetary policy, carry trades and the possibility of official intervention.
For FX traders, the lesson is broader.
Do not assume that softer US inflation automatically produces sustained dollar weakness. Interest-rate differentials, geopolitical demand for the dollar and relative economic performance remain equally important.
The market is becoming more dependent on confirmation
For traders, the current environment argues against relying on any single economic release.
Instead, several signals should be monitored together:
- US consumer spending, to determine whether weaker employment is beginning to affect demand.
- Treasury yields, particularly whether the 10-year yield can decline sustainably rather than simply react temporarily to softer inflation releases.
- The US dollar, to see whether reduced Fed tightening expectations translate into broad currency weakness.
- USD/JPY, where monetary-policy divergence and intervention risk are approaching an important confrontation.
- Oil, because another geopolitical increase could quickly change the inflation outlook again.
- Corporate earnings, to determine whether slowing macroeconomic momentum is beginning to affect profits.
The relationship between these markets may tell investors more than any individual headline.
Markets may have changed risks rather than eliminated them
This week’s inflation numbers were encouraging.
They reduced the immediate probability that the Federal Reserve will need to tighten aggressively again, and markets were justified in reacting positively.
But softer inflation does not automatically create a low-risk environment.
The economic balance may simply be changing.
Several months ago, the central danger was that growth remained too strong while inflation refused to fall.
Today, the emerging danger is different: inflation may moderate while employment and demand weaken at the same time.
That would leave the Federal Reserve with an increasingly difficult trade-off and investors with fewer obvious conclusions from economic data.
Markets have spent much of this year celebrating bad economic news because it reduced expectations for higher interest rates.
The next stage may be more demanding.
Weak data can support markets when it changes monetary policy expectations. It becomes dangerous when it starts changing earnings expectations.
For investors and traders, identifying that transition may now matter more than predicting the next Federal Reserve decision.
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