Fed still on narrow path to soft landing

Despite only being at the start of the second week of the new year, we’ve already had some significant economic data from Europe and the US, which has helped rates markets to reverse some of their year-end sell-off. 

Last week in Europe headline inflation data surprised to the downside for a second consecutive month, coming in at 9.2% year-on-year vs. 9.5% expected and 10.1% for the prior month, while the month-on-month print was negative again at -0.3%. With producer price inflation also being better than expected, only Core CPI disappointed, being slightly higher than expected at 5.2%.  Rates investors liked what they saw, and 10-year German Bunds rallied 35bp in the first week of the year, with peripheral government bonds also rallying.

In the US we await inflation numbers on Wednesday, with yearly headline and core inflation expected to fall again from last month’s reading. The mom print could also be very significant; a reading of 0.0% is expected, which would mean the annualised rate for the last three months being very close to 2%, the Fed’s target.  

So far, however, it has been Friday’s jobs data that has firmly driven markets. To recap, non-farm payrolls rose by 223k, once again ahead of expectations, with the unemployment rate falling to 3.5% from a revised 3.6% in the previous month. However, both monthly and yearly average hourly earnings came in below expectations and below last month’s readings, which were also revised down. We also had Services ISM data on Friday, which came in significantly below expectations and last month’s data, and below 50 for the first time since 2020, signalling the services economy was contracting.  

Obviously economic data moves with a lag, particularly employment data, but so far the data points to a scenario whereby Fed policy is softening the economy, thereby lowering inflation but without negatively impacting employment, which would obviously be a desired outcome. We know how important the labour market is to the Fed, and we felt it would ultimately have to engineer higher unemployment to get inflation back to target. This was one of the components that led to our 2023 base case  that the US economy would experience a ‘softish’ landing (a mild recession with unemployment and default rates staying well below levels seen in previous recessionary cycles). This view hasn’t changed, but the Fed is going to be data dependent, and we have to acknowledge that the recent data has somewhat increased the possibility that the US economy does escape with a soft landing, with the caveat of the lag mentioned above.

Rates markets certainly liked the data, and 10-year Treasuries had rallied back to 3.55% at the close on Friday, from 3.9% at the start of the year. Interest rate expectations show markets are still expecting a pivot from the Fed later this year, but as the chances of a soft landing increase, so the chances of a pivot must decrease. If labour markets stay strong even as inflation falls, one of the catalysts for the Fed needing to pivot also disappears. This has obvious consequences for US rates bulls, probably decreasing some of the UST rally potential, but that is not necessarily a negative in our view. USTs are now generating yield and income for investors even in the absence of a rally, and of course a soft landing should be supportive for credit. 

It is early days, and the inflation prints later this week could be the next driver for markets, followed by the earnings season which will soon be upon us. For now though sentiment is buoyant, which makes a welcome change from 2022.