Week ahead: Central banks, earnings, economic data

This is the peak of the summer, and it feels like it will be the peak week for financial markets. The Fed, the BOE and the BOJ all meet this week, while Amazon, Apple and Microsoft report Q2 earnings and at the end of the week the US will release its latest labour market report. Markets have failed to so far give off a summer vibe: there have been sharp sell offs and big negative reactions to earnings data, added to that political risks have taken centre stage. However, now that political risks have taken a back seat with Joe Biden pulling out of the US Presidential race, the markets can once more focus on the fundamental factors that will drive markets for the long term.

Political risks recede

It is worth noting that the latest polls in the US suggest that November’s Presidential race will be tight. The latest poll by Nate Silver, a famous US pollster, shows that Trump is set to win a mere 1.3% more of the vote than Kamala Harris. Harris has added a shot of adrenaline into the Democratic campaign, and with her as the Democratic nominee, they have less of a third-party problem. This is a two-horse race, and the fact that the polls are rapidly tightening makes it less likely that Trump and the Republicans will be able to win both the White House and Congress later this year. This is important, since a divided White House and Congress limits political interference in the US economy and elsewhere, which markets like.

All of this is to say, that in the past week US political risk has melted away, which allows investors to focus on fundamentals. This is important since it is a huge week for markets.

The Federal Reserve: What to expect?

The FOMC meeting will conclude on 31st July, there will be a statement and a press conference led by Jerome Powell. Although no change in rates is expected, the market will be looking for a clear signal that a rate cut is coming at the next meeting in September. We think that this will be confirmed this week, as the Fed has now amassed a large amount of evidence to suggest that inflation is moderating sufficiently and that the labour market is softening. The latest inflation data, the core PCE for June, slowed to its slowest pace in more than 3 years. Importantly for the Fed, personal income grew by a 0.2% rate last month, which could be a further sign that wage pressures are easing.

Fed meeting: unemployment in focus

Even though long term inflation expectations compiled by the July University of Michigan consumer confidence report showed expected price increases in a 5–10-year time frame rising to 3% from 2.9%, we do not think that these will deter the Fed from cutting rates in the coming weeks. We believe that at this week’s meeting, the Fed will confirm that they are happy with the disinflationary trend, which has returned after a blip during the winter months. However, we also think that the Fed will suggest that they are now more focused on the unemployment rate. The Fed has a dual mandate: inflation and full employment. By failing to cut rates in the coming weeks, they threaten the second part of their mandate. The unemployment rate is higher by 0.7% since reaching a low of 3.4% in January 2023. So far this year, the unemployment rate has risen by 0.4%. If it continues to rise at this pace, the Fed could soon have an economic crisis on its hands.

The market is expecting the US economy to have created 175k jobs in July, which is down from 206k in June. Even if payrolls surprise to the upside, which they have done in recent weeks, the household survey of US employment, which measures the unemployment rate, has consistently been weaker than the establishment survey that collates the NFP report. Thus, unless we see a shock decline in the unemployment rate on Friday, we think that the Fed will cut rates in September and may continue to cut rates at each meeting through to the end of the year.  

There is currently 68-basis points of rate cuts priced in by the market from September to December, which is nearly one cut for every meeting until the end of the year. While a rate cut is fully priced in for September and there is a 93% chance of a cut in December, how concerned Jerome Powel and co. are about the unemployment rate could determine whether the market boosts the chances of a November rate cut, which currently stand at 64%.

Watch the Fed’s terminal rate

Interestingly, from a market perspective, stock markets sold off sharply even though a US rate cut was fully priced in for September. Thus, confirmation of a September rate cut at this week’s Fed meeting will not be enough, instead, we think that the Fed will need to signal 1, deep concern at recent labour market trends, and 2, signal that the US economy may need a materially lower R* rate, or terminal rate, which may spur the equity market into further recovery mode after the sharp selloff in recent days, especially in tech stocks. Interestingly, the drop in the 10-year Treasury yield combined with rate cut expectations from the Fed, have fueled the recovery in mid-cap and value stocks, and the Russell 2000 continues to outperform the Magnificent 7 mega cap tech stocks.

If the Fed wanted to avoid being accused of political bias, then they may cut rates at this week’s meeting. However, the market is not expecting a rate cut with only a 4.5% chance of a cut currently priced in. Thus, we do not think that they will rock the boat this week. Instead, they will bat away suggestions of political bias by saying that they remain data dependent.

Will the BOE cut rates?

The Bank of England also meet this week. They will announce their latest interest rate decision, and their latest Monetary Policy Report, which will include GDP and inflation expectations. The market is currently only pricing in a 44% chance of a rate cut from the BOE this week, and there are only 38bps of rate cuts priced in for the rest of this year. The market has been reluctant to price in rate cuts for a few reasons: residual inflation risks, especially service price inflation, some hawkish members of the BOE coming out and saying they won’t vote to cut rates at this meeting, and the chance of an upgrade to the BOE growth forecasts for this year and next. The latter point is worth noting, it would be odd for the BOE to cut rates at the same time as they raise their growth forecasts, and due to this we think that they won’t cut rates at this week’s meeting.

The BOE could signal future rate cuts this year

However, the BOE has plenty of room to cut interest rates. The sharp drop in the UK’s headline inflation rate means that real interest rates in the UK are higher than rates in the Eurozone and the US. Thus, the BOE has room to cut rates. If they don’t cut rates at this meeting, we think that they will signal rate cuts are coming down the line, due to upward pressure on the unemployment rate.

The pound has been the best performing currency in the G10 FX space so far this year, in part due to the reduction of the political risk premium and also due to the beneficial yield differential it has with other currencies. However, GBP/USD has been making hard work out of breaking above the $1.30 level and this pair fell 0.2% last week. One of the reasons why this has happened is because of the death of the carry trade in the last two weeks. The market has bought the yen across the board, and this is limiting GBP upside for now. We will be watching to see if the BOE meeting can give the GBP a boost as we move into August.

It is worth noting that a number of analysts think that the BOE will vote to cut rates this month, however we think that the rationale that the BOE only cuts rates when they release Monetary Policy Reports won’t stand this time.

The big test for the Yen  

There is a big test for the yen recovery this week. The BOJ also meet on Wednesday. There is a 68% chance of a small rate hike at this meeting. However, of more interest to traders will be what the BOJ says about quantitative tightening, as it tries to reduce the rate of assets that it buys every month. Last month the governor of the BOJ said that the reduction in bond buying would be sizeable. They may signal that they will cut monthly bond purchases from 6 trillion yen per month to 4.5 trillion yen, with a target of 2 trillion yen in the next two years. Some in the market expect the BOJ to announce cuts to its bond purchases, however, they expect shallower cuts. It is true that the BOJ has wrong footed the market before, however, we think that the stars have aligned and larger cuts to BOJ bond purchases are on the cards at this meeting. If the BOJ also signals another rate hike in October, then USD/JPY may fall back to the 150.00 level, which we believe is more comfortable for the Japanese authorities.

Central banks could boost risk sentiment

Overall, central bank meetings this week, aside from the BOJ, could signal that central bankers in the UK and the US have orchestrated a soft landing for their economies. They are expected to cut rates or signal rate cuts are coming before unemployment rates rise to worrying levels. This should be good for risk sentiment, especially for cyclical and value stocks, and it should support the catch-up trade for mid-cap stocks and stocks excluding the mega cap tech stocks.

Microsoft earnings: can they boost the AI trade?

Big tech will be in focus this week, with earnings from Amazon, Apple and Microsoft. We believe that Microsoft’s results will be scrutinized, after Google failed to set the world alight with its update on how its AI investments are benefiting its bottom line. Microsoft reports earnings on Tuesday night. The market is expecting revenue of $64.5bn, with EPS of $2.94 and net income of $22.04bn. Analysts have been bullish about Microsoft’s results in the last 4-weeks and have upgraded their forecasts. However, it is worth noting that Google’s profit levels and costs failed to impress the market and its share price fell more than 7% last week, even though it posted larger than expected revenues for last quarter. Microsoft’s share price has risen 4.2% on average in the 1-day after earnings releases for the last 8 periods. The market will be focused on how co-pilot is generating revenue and also costs. The market has a distaste for unbridled spending on AI, so if Microsoft does not reign in its spending plans, then it may get punished.