Market Brief: Volatility Subsides As Inflation Dust Settles

Price action is slowing in financial markets after yesterday’s US inflation report definitively cleared the way for a September rate cut, yet stopped short of justifying an unusually-large half-percentage-point move. Both the headline and core consumer-price indices rose at the slowest pace in three years in July, but shelter costs failed to match the prior month’s swift deceleration, putting the onus on forthcoming labour market data to determine whether a faster pace of easing is justified.

The dollar is holding near an eight-month low, Treasury yields are little changed, and stock market futures are setting up for an incrementally-stronger open. The Canadian dollar is grinding higher amid a paucity of domestic economic data, with further gains looking likely as cross-asset volatility levels continue their decline.

This morning’s data dump could provide clarity around the margins. Forecasters think the number of initial unemployment claims submitted in the week ended August 10 will climb from the prior week, printing near the 235,000 mark, up from 233,000, even as continuing claims edge down. With the higher-frequency Johnson Redbook same-store sales measure remaining strong, headline retail sales are seen rising 0.4 percent in July, while the control-group aggregate - which excludes autos, gas, food, and building materials - turns modestly negative after a blistering-hot 0.9-percent jump in the prior month. Industrial production might slip into negative-growth territory after the Institute for Supply Management’s purchasing manager index pointed to a softening in activity during the month of July.

Jerome Powell could provide clearer easing guidance during next week’s appearance in Jackson Hole, Wyoming. The agenda for the Kansas City Fed’s annual Economic Policy Symposium hasn’t been made public yet, but if the chair appears, he is widely expected to further shift his communications emphasis toward the second half of the central bank’s mandate, highlighting downside risks to employment and doubling down on previous assertions about the “restrictiveness” of current policy settings. If consensus estimates are correct, the core personal consumption expenditures deflator will print close to the 2.7 percent mark upon release later this month, 2.675 percent lower than the midpoint of the current Fed Funds target range, implying the highest level of “real” rates since the run-up to the 2008 global financial crisis.

But the August payroll report on September 6 will prove pivotal in determining the extent to which policymakers deliver on market expectations for an aggressive easing cycle. A sub-125,000 print might reinforce market odds on an initial half-percentage-point cut, with more easing coming at back-to-back meetings through the end of the year. In contrast, a recovery in the headline job creation pace - back to 175,000 or above - could take a jumbo-sized move off the table for September and push the median “dot plot” economic projection toward showing just two more cuts in November and December, disappointing swaps traders and pushing the dollar higher.

The British pound is holding firm after the economy maintained its growth trajectory in the second quarter, supporting the case for a cautious approach to easing monetary policy from the Bank of England. According to the Office for National Statistics, gross domestic product grew at an annualised 2.3-percent pace in the three months ended June, with a slight deceleration toward the end of the quarter likely coming from election-related uncertainty (and a lack of Taylor Swift concerts) - suggesting that the handoff to the second half remained strong. Traders are pricing two rate cuts before year end, but we see risks biased toward a more gradual trajectory, with the pound exposed to upside gains if policymakers prove more timid than currently expected.

Crude oil benchmarks remain surprisingly quiescent, suggesting that the “geopolitical tensions” mooted in many sell-side research reports are having little to no effect on underlying market assumptions. Measures of geopolitical risk look elevated relative to long-term averages, but oil markets seem well-insulated, with seasonal demand growth fading, the Chinese economy generating below-trend growth, and the United States producing at near-record levels. Both the Brent and West Texas Intermediate price gauges are up less than 2 percent on the month, despite the threat of an Iranian strike on Israel in the coming days or weeks. This may not last.

Correction: In yesterday’s note, I mistakenly said that the all-items inflation basket rose 3.2 percent in the year to June (the month prior to yesterday’s print). It increased 3.0 percent. My apologies for the error.