Recession vs. inflation battle rages on

The recession vs. inflation battle is increasingly shifting towards the former as reflected in the recent paring back in US Federal Reserve tightening expectations and growing market pricing of rate cuts beginning as soon as early next year.  The weakness in the US July Services purchasing managers index (PMI) added more weight to this argument.  This week's second quarter US Gross Domestic Product (GDP) data is likely to confirm two quarters of negative growth, which should mean technical recession though in the case of the US, recession is defined by the US National Bureau of Economic Research (NBER) as “a significant decline in economic activity that is spread across the economy and lasts more than a few months”.  Either way, the US economy is on a softer path.

This week is a big one for events and data.  The Fed is widely expected to cut US policy rates by 75 basis points tomorrow.  Expectations of a bigger 100bps move have been pared back.  If the Fed does hike by 75bp it will likely result in interest rates reaching a neutral rate (the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive).  At this meeting there will be a lot of focus on the Fed's forward guidance but in reality the magnitude of hikes at the next FOMC meeting in September will be contingent on key inflation releases and other data, with two inflation reports (10 August and 13 September) to be published ahead of the next Fed meeting.

In Europe there was yet more disappointing economic news this week, with the German July IFO business sentiment survey falling sharply. The data gave a similar message to last week's weak PMIs, provides yet more evidence that the German economy is falling into recession.   News that Russia has cut gas deliveries to Europe through Nord Stream 1 will only add to such concerns.  After surprising with a 50bp rate hike last week, the ECB arguably faces a bigger problem than the Fed.  At least in the US, the consumer is still quite resilient, with demand holding up well, while in contrast, demand is weak in Europe and the economy is sliding into recession at a time when inflation is around four times higher than target. 

Emerging markets have found some respite from the pull back in the US dollar over recent days, but it is questionable how far the dollar will sustain any pull back.  Increased worries about the US economy and a paring back of Fed tightening expectations could damage the dollar further, but let's not forget that the Fed is still tightening more rapidly than many other major central banks, which ought to limit any US dollar weakness.  Even so, even if it’s a short-term phenomenon, emerging market currencies and bonds will find some relief from a softer dollar tone for now.  That said, many frontier economies such as in North Africa and South Asia are likely to struggle from higher food and energy prices for some months to come. If the dollar does resume its ascent it will only add to their pain.