The Week Ahead: US inflation in focus

As we start a new week the dollar is rallying, and 10-year US Treasury yields are surging once more and are up 5 basis points at the start of a new week. Although yields fell after July’s Non-Farm Payrolls were lower than expected, yields were still higher on the week and at 4.09% at the time of writing, 10-year yields are close to the 14-year high of 4.23% reached last October. While yields along the curve are rising on Monday, there is a clear trend, with shorter term yields falling in recent weeks, while the 10-year yield continues to rise. When longer term yields rise above shorter-term yields, this is called bear steepening, and it suggests that the market sees the peak for Fed Funds rates coming soon, however, it also suggests that the market sees higher rates sticking around for longer. When this happens it is worth noting, as higher rates that linger for longer can take the shine off economic growth, and therefore stocks.

The bear steepener that could spook the market

A bear steepening Treasury curve is one way to explain the downturn in US stocks since the end of July, the Nasdaq fell more than 2% last week, and the S&P 500 fell nearly 2%. The malaise in stocks, comes even though the number of companies on the S&P 500 who have reported earnings that are beating expectations is above its 10-year average, the magnitude of these positive earnings surprises is also above the 10-year average. However, not even better than expected earnings, particularly for the consumer discretionary and communications sectors, is having an impact on the performance of stock indices. This may be explained by the fact that even though earnings are beating expectations, they are still negative compared with Q2 2022. On aggregate, earnings are -5.2%, less than the -7.4% recorded at the end of last week, but a 5.2% decline in earnings for Q2 would still be the largest YoY decline in earnings since Q3 2020.

Will US inflation surprise on the upside?

Thus, while it is easy to get excited about interest rates reaching a top, it is worth noting that there are plenty of challenges ahead. The interest rate narrative will be in full force this week as we wait for US inflation data for July, which is released on Thursday. The market is expecting 0.2% growth for both headline and core prices last month, however the headline annual rate is expected to rise to 3.3% from 3% in June, while the core rate is expected to fall further to 4.7% from 4.8%. The rise in headline prices is expected to come from volatility in the oil price, and rising gasoline prices that have occurred during peak driving season in the US, along with rising wheat prices. While the market will fixate on the CPI figures on Thursday, it is worth noting that the Federal Reserve prefers the core PCE inflation measure when it comes to deciding on policy. It is also worth watching producer price data that will be released on Friday. There are some concerns that commodities will rise in price ahead of the winter. This comes after Saudi Arabia appeared committed to production cuts to boost the oil price. Brent crude may be falling on Monday; however, it was higher by 0.7% last week, and it has gained more than 10% in the past month, which is a trend to watch. If commodity prices do trend upwards then this will pose a threat to central bankers’ attempts to bring inflation under control. If this trend does persists then we then should see it develop in producer prices first. The market expects producer prices to rise 0.1% last month, but if this is stronger than expected, then we could see some risk aversion permeate financial markets.

China could fall into deflation

Elsewhere, Chinese inflation figures are always worth watching, not least to see if the deflation trend in China is continuing. The market expects 0% inflation for July, with prices falling 0.5% on an annual basis. If prices do fall into negative territory, it would be the first time since 2020. Producer prices in China are also expected to decline by 4% last month, although this is higher than the -5.4% recorded in June. Thus, this week’s price data is expected to highlight the differences between China and the West when it comes to price growth. Deflation in China suggests that its growth picture has not improved, however, if negative price growth is confirmed on Wednesday, then we could see some PBOC support to try and boost growth. So far, the PBOC has been slow to offer monetary support to the economy, if it does happen then we could see risk sentiment rise across the board.

UK GDP stalls

Elsewhere, it’s also worth watching the UK GDP figures for Q2. Analysts are expecting no growth in Q2 vs. Q1, with growth for June expected at 0.2%. The global expansion generally increased in Q2, however, there are signs that growth is slowing, and this is expected to be evident in the UK figures. Added to this, growth in the UK has been largely driven by the service sector, however, there is likely to be evidence that service sector growth is slowing down, the index of services for the three months to June is expected to come in flat. This is both a blessing and a curse: it could slow service sector inflation, which has weighed on core price growth for most of the past year, however, it could also signal that a recession is on the cards for the UK. Signs of a faltering service sector in the UK comes after house prices fell for the fourth consecutive month, according to Halifax. According to Halifax, house prices fell 0.3% last month, and 2.4% compared to a year ago. Falling house prices are driving weak consumer confidence and could weigh on the service sector later this year, which is a warning signal for UK growth. With this economic backdrop, it’s no wonder that GBP/USD fell nearly 1% last week, although 2-year gilt yields are jumping on Monday, which is part of a global trend as fears increase about rising commodity prices.

On the back of the UK GDP figures, it’s worth watching out for the commentary from the Bank of England’s chief economist, who speaks later on Monday. We will be listening out for concerns about growth, and any comment about the 3-way split at last week’s MPC meeting.