Overview
Markets have reacted strongly to recent data that suggests further weakening in the US labour market. Global stocks have had a volatile start to August, while ten-year treasury yields rose above those on two-year treasuries for the first time since July 2022 before normalising on Monday.
These price moves reflect growing fears that the jobs data signals imminent recession in the US. We think those fears are misguided. The uptick in unemployment over July can be largely explained by the supply of labour, reflected in the higher participation rate (i.e. more people of working age either in employment or looking for work). Moreover, the report showed a large number of temporary layoffs, which has the potential to reverse in the coming months. Consequently, the employment-to-population ratio, particularly for prime age workers, remains steady.
But market concern is understandable, especially after a slowing in the pace of economic growth and a broad-based easing in price pressures. We expect this trend to continue, with momentum moderating through the rest of the year.
That means recession risk is rising, but not to levels we are uncomfortable with. Growth is unlikely to fall off a cliff and economic fundamentals remain fairly resilient. Consumer and corporate balance sheets look healthy. Our base case remains a soft landing, with a probability of 55 per cent, and a 30 per cent probability of recession.
However, while we do believe markets are overreacting, it is important to remember that excessive market moves can quickly spiral and impact confidence, spending, and ultimately growth. The more drawn-out and extreme these moves become, the greater the risk that they trigger a recession. We are monitoring the current situation closely: a further tightening of financial conditions would lead us to increase the probability of recession for 2024.
How will the Fed respond?
Given we don’t believe today’s volatility is a harbinger of recession, we still expect the US Federal Reserve to cut interest rates by 25 basis points in September and December. But we won’t know the severity of risks now emanating from financial markets until it is too late, which could then warrant a strong central bank response. That means we cannot discount the possibility of more frequent and bigger cuts (up to 50 bps), were financial conditions to tighten further. The Fed could release an official statement to quell immediate market concerns, saying it is watching developments closely and stands ready to act if market turmoil starts to affect liquidity and the outlook for monetary policy.
The view beyond 2024 and into the first half of next year becomes more uncertain due to the US election. If the outcome leads to significant policy changes, particularly on trade and immigration, it could have a material impact on the outlook for 2025.
