UNITED STATES: Navigating a Gentle Breeze
Key risk events in the five-week outlook include FOMC minutes, US CPI data, and NATO Summit.
Tuesday, 02 July, Week 27: The US economy is currently experiencing a period of moderated growth, akin to sailing with a gentle breeze. While not facing a full-blown gale, the economy is encountering some headwinds from persistent inflation and the Federal Reserve's cautious approach to monetary policy. The coming five weeks will be crucial for assessing the strength of these headwinds and determining whether the US economy can maintain its course or if it will require a change in direction.
Fiscal Policy
Fiscal policy influences economic growth, inflation, and financial markets, impacting monetary policymakers and investors.
President Biden's 2025 Budget proposal, released in March, has set the stage for fiscal policy discussions in the coming months. The proposal outlines a plan for significant investments in key areas, including childcare, education, healthcare, and clean energy, while simultaneously aiming for deficit reduction through tax reforms targeting wealthy individuals and corporations. The proposed investments, totalling hundreds of billions of dollars over the next decade, are intended to boost economic growth and address social inequalities. However, these investments could also contribute to inflationary pressures, particularly if supply chains remain constrained. This potential inflationary impact could complicate the Fed's efforts to bring inflation down to its 2% target and could lead to a more cautious approach to interest rate cuts.
The budget's proposed tax reforms, which include a 25% minimum tax on the wealthiest 0.01%, increasing the corporate tax rate to 28%, and closing various tax loopholes, are aimed at generating trillions of dollars in revenue over the next decade. These reforms, if enacted, could have a significant impact on financial markets, potentially leading to volatility in equity and bond markets as investors assess their impact on corporate profits and investment decisions. The market reaction to these reforms will depend on the final details of the legislation and the perceived likelihood of their passage through Congress.
The 2025 Budget proposal is currently under congressional review, and the final outcome will likely differ from the initial proposal. The political climate and the upcoming presidential election could significantly influence the negotiations and the final budget agreement. The implementation of the proposed investments and tax reforms will also take time, and their full impact on the economy and financial markets will likely be gradual.
Economics
Economics analyses resource allocation and influences growth, inflation, employment, and trade. It aids policymakers and investors in decision-making and risk assessment in financial markets.
The US economy is currently experiencing a period of transition, moving from a period of robust, pandemic-driven growth to a more sustainable pace of expansion. This transition is being shaped by several key factors, including the Fed's monetary policy tightening, ongoing supply chain disruptions, strong consumer demand, and mixed business investment.
The Fed's aggressive interest rate hikes over the past year have slowed economic growth and cooled demand in certain sectors. The impact of these rate hikes is becoming more evident in recent economic data, such as the ISM Manufacturing PMI, which has indicated contraction for three consecutive months. However, consumer spending remains relatively robust, supported by a strong labour market and accumulated savings. This suggests that the US economy is currently experiencing a gentle breeze, with some headwinds but also some tailwinds.
The outlook for the next five months is uncertain, as the Fed attempts to navigate the delicate balance between controlling inflation and supporting economic growth. The central bank will need to carefully calibrate its monetary policy to avoid both excessive inflation and a sharp economic downturn. The global economic outlook, which remains clouded by geopolitical tensions, supply chain disruptions, and the ongoing war in Ukraine, will also play a role in shaping the US economic trajectory.
Economic Growth:
GDP Growth Rate (QoQ): 1.3% (2nd est. February), 1.4% (3rd est. March)
GDP Annual Growth Rate: 3.1% (March), 2.9% (April)
ISM Manufacturing PMI: 48.7 (February), 48.5 (March), 48.5 (June)
S&P Global US Manufacturing PMI: 51.7 (prelim. March), 51.6 (June)
The US economy has experienced a slowdown in GDP growth in the first quarter of 2024, with the third estimate confirming a 1.4% expansion. This slowdown was driven by a deceleration in consumer spending, a downturn in federal government spending, and a decrease in private inventory investment. The ISM Manufacturing PMI has indicated a contraction in the manufacturing sector for three consecutive months, suggesting a weakening in this segment of the economy. However, the S&P Global US Manufacturing PMI suggests an improvement in the sector, highlighting the need to consider multiple indicators for a comprehensive assessment.
Forecasts for the coming months suggest that economic growth will continue to moderate, with the Atlanta Fed's GDPNow model currently estimating Q2 GDP growth at 1.8%. The risk of a recession in the US remains elevated, with some economists predicting a downturn in late 2024 or early 2025. The Conference Board's Leading Economic Index has declined for 14 consecutive months, a historical precursor to recessions.
Labour:
Unemployment Rate: 3.9% (February), 3.8% (March), 3.9% (April), 4.0% (May)
Non Farm Payrolls: 232K (3-month avg. February), 267K (3-month avg. March), 165K (revised April), 272K (May)
Average Hourly Earnings (Private): $34.77 (April), $34.91 (May)
The US labour market remains tight, with the unemployment rate hovering near historic lows. However, the unemployment rate has ticked up slightly in recent months, suggesting a potential easing in labour market tightness. Nonfarm payrolls have continued to increase at a solid pace, although the April figure was revised downward. The May figure showed a significant rebound in job growth, exceeding market expectations. Average hourly earnings have continued to increase, indicating continued upward pressure on wages.
The Fed's monetary policy tightening could lead to a softening in the labour market in the coming months, potentially resulting in slower job growth and a gradual increase in the unemployment rate. Wage growth is expected to remain elevated in the near term, as businesses compete for workers in a tight labour market. However, wage growth could moderate if the labour market softens and demand for labour cools.
Price Changes:
Inflation Rate (YoY): 3.2% (February), 3.5% (March), 3.4% (April), 3.3% (May)
Inflation Rate (MoM): 0.6% (February), 0.6% (March), 0.4% (April), 0.0% (May)
Core PCE Inflation (YoY): 3.0% (February), 3.4% (March), 2.8% (April)
Core CPI (YoY): 4.0% (March), 4.1% (April), 3.4% (May)
Headline inflation has eased in recent months, with the CPI showing a smaller year-on-year increase in May compared to April. The decline in gasoline prices has contributed to the slowdown in inflation. The May CPI report showed a 0.0% month-on-month change, the least since July 2022. However, core inflation, which excludes volatile food and energy prices, remains elevated, suggesting that underlying inflationary pressures persist. The core CPI remained at 3.4% year-on-year in May, while core PCE inflation was 2.8% in April.
Inflation is expected to continue gradually declining in the coming months, as supply chain disruptions ease and the Fed's monetary policy tightening takes full effect. However, the pace of disinflation remains uncertain, and there are risks that inflation could prove more persistent than expected. The Fed will be closely monitoring inflation data, particularly core inflation, for signs of a sustained decline.
Trade:
Balance of Trade: -$69.0B (February), -$68.6B (revised March), -$74.6B (April)
Current Account: -$221.8B (revised Q4 2023), -$237.6B (Q1 2024)
Current Account to GDP: 3.8% (2022), 3.0% (2023)
The US trade deficit has widened in recent months, reaching its largest level since October 2022 in April. This widening was driven by a surge in imports, particularly of passenger cars, computer accessories, and crude oil. The current account deficit, which reflects the combined balances on trade in goods and services and income flows, also widened in the first quarter of 2024, primarily due to an expanded deficit on goods. However, the current account deficit as a percentage of GDP has declined in 2023 compared to 2022, indicating a slight improvement in the external balance of the US economy.
The outlook for the US trade balance in the coming months is uncertain. Ongoing trade tensions with China and other countries could impact the trade balance, potentially leading to further widening of the deficit. The implementation of US tariffs on Chinese electric vehicles and other strategic goods in August could exacerbate trade tensions and weigh on the trade balance. The impact of global growth on the US trade balance will also be a key factor to watch, with a slowdown in global growth potentially leading to weaker demand for US exports.
Monetary Policy
Monetary policy, managing interest rates and money supply, influences economic activity and inflation, affecting borrowing, spending, investment, employment, and price levels.
The Federal Reserve has been navigating a challenging environment over the past five months, as it seeks to bring inflation down to its 2% target without causing a sharp economic slowdown. The central bank has raised interest rates aggressively over the past year, and these rate hikes are starting to have a noticeable impact on economic activity. However, inflation remains elevated, and the Fed has signalled a cautious approach to potential rate cuts.
The FOMC left the fed funds target range unchanged at 5.25%-5.50% in June, marking the seventh consecutive meeting without a rate change. The Fed's dot plot projections now indicate two rate cuts in 2024 and two in 2025, reflecting a more cautious approach to loosening monetary policy. The Fed has emphasised its commitment to bringing inflation down to its 2% target and has indicated that it will not cut rates until it has gained greater confidence that inflation is moving sustainably toward that goal.
The Fed's current monetary policy stance is creating a moderate headwind for the US economy. The high interest rates are making it more expensive for businesses to borrow and invest, and are also cooling demand in interest-rate-sensitive sectors like housing. However, the Fed's cautious approach to rate cuts suggests that it is willing to tolerate some economic slowdown in order to ensure that inflation is brought under control.
The outlook for monetary policy in the coming months is data-dependent. The Fed will be closely monitoring incoming data on inflation, labour market conditions, and economic growth to assess the impact of its policy actions and adjust its stance as needed. If inflation continues to ease and economic growth moderates as expected, the Fed could begin cutting interest rates later in 2024 or early 2025. However, the timing and pace of rate cuts remain uncertain, and will depend on the evolution of the economic data.
Market Risk
Market risk, inherent in investing, can impact markets, economy, and policy decisions. Understanding and managing it are vital for investors and policymakers.
Significant Risk:
US Presidential and Legislative Elections (November 5th, 2024): The US elections will have a significant impact on the USD and global markets. The outcome will determine the country's economic and foreign policies. Uncertainty surrounding the election might initially weaken USD, particularly against safe-haven currencies like JPY and CHF (USD/JPY, USD/CHF bearish). However, a clear outcome and policy direction, particularly if it involves fiscal stimulus or a more hawkish stance on trade, could strengthen USD, leading to weakness in other major currencies (USD/JPY, USD/CHF bullish).
China's Third Plenum of the 20th Central Committee (July 15th-18th, 2024): This meeting will focus on China's economic direction. Announcements regarding stimulus measures, trade policies, or structural reforms could significantly impact Asian currencies, particularly CNY. Positive economic signals and a commitment to opening up the Chinese economy might strengthen CNY, particularly against USD (USD/CNY bearish). However, any negative news, a continuation of zero-Covid policies, or escalating trade tensions could weaken CNY, leading to strength in USD and JPY (USD/CNY bullish, CNY/JPY bearish).
Implementation of US Tariffs on Chinese EVs and Other Strategic Goods (August 1st, 2024): The implementation of US tariffs on Chinese goods will likely escalate trade tensions and impact USD/CNY. This could weaken CNY and potentially strengthen USD as investors seek safe-haven assets (USD/CNY bullish). However, the impact on USD might be limited if the tariffs negatively affect US businesses and consumers, potentially leading to weakness against other major currencies like EUR and JPY (EUR/USD, USD/JPY bearish). Additionally, any retaliatory measures from China could further complicate the situation and increase market volatility.
Minor Risk:
FOMC Minutes (July 3rd, 2024): The FOMC minutes could provide clues on the Fed's rate cut timeline, potentially impacting USD.
US CPI (July 11th, 2024): US inflation data will be crucial for USD and Fed policy expectations.
NATO Summit (July 9th-11th, 2024): The NATO summit could impact EUR and USD depending on the outcome of discussions regarding Ukraine and Russia.
Conclusion
The US economy is currently facing a moderate headwind, with slowing growth and persistent inflation creating a challenging environment for policymakers and investors. The Fed's cautious approach to monetary policy suggests that it is willing to tolerate some economic slowdown in order to ensure that inflation is brought under control. The coming weeks will be crucial for assessing the strength of these headwinds and determining whether the US economy can maintain its course or if it will require a change in direction.
For forex traders, the USD is likely to remain sensitive to economic data releases, particularly those related to inflation and the labour market. The upcoming FOMC minutes and CPI report will be closely watched for clues on the Fed's policy intentions. Additionally, geopolitical developments, particularly those related to the war in Ukraine and US-China relations, could also impact the USD.
Reference:
Bloomberg
Federal Reserve
U.S. Bureau of Labor Statistics
U.S. Bureau of Economic Analysis
U.S. Census Bureau
Office of Management and Budget, The White House
U.S. Treasury
Internal Revenue Service
Institute for Supply Management
S&P Global
University of Michigan