July rate cut unlikely

Stronger US jobs data dims July rate cut hopes, while UK braces for tax hikes and Australia eyes easing amid mixed global economic signals.

• US: July Rate Cut Unlikely, But Still Needed
• UK: Tax Hikes Are Expected in Autumn Budget
• Australia: Consensus Agrees With Us
  
• Spotlight on Next Week

US: July rate cut unlikely, but still needed

It is turning into a bit of a pattern: a payroll report that bests expectations on headline, but with weak details. This was certainly the case in May, when solid employment gains during that month were accompanied by a massive downward revision to the prior two months. And it was also the case in June, when the 147,000 payroll gain bested consensus expectations but was heavily driven by the government sector. For its part, private sector employment rose less than expected and there were modest downward revisions to the prior months as well. The unemployment rate dipped 0.1 percentage point to 4.1% amid another 0.1 percentage point decline in the labor force participation rate.

What to make of all this? Perhaps the only clear conclusion to be drawn—and the market has indeed drawn it—is that the Fed is now highly unlikely to cut rates in July. Fine. But the bigger question is whether a cut in July would make sense given economic conditions. We believe so, and have laid out a detailed argument here. Given the long lags with which policy operates and given the criticality of maintaining full employment, we would argue against too upbeat an interpretation of the latest jobs data. In short, this report should not, by any means, be seen as putting to rest growing concerns about the health of the labor market. The buoyancy in government employment (largely state level education) does not seem to correlate with broader policy signals. It seems, therefore, more of a seasonality abnormality than a true sign of strength. And given what is to come once federal employees currently receiving ongoing severance fall out of the employed ranks (likely in October), we should anticipate a big hit to employment in the fall. Why wait until it happens?

Evidently, the arguments for a July cut are not crystal clear, or else the FOMC would likely deliver it. However, there is danger in waiting until there is no ounce of doubt left—recall the delay in the hiking cycle in 2022? Yes, there are worries about the inflationary impact of tariffs, but with the deadline for a potential lift in tariff rates now August 1 (for countries who do not have a trade deal in place by then), it seems unlikely that we’ll see much evidence of tariffs in the inflation data either by July 30 or September 17 meetings. Does the Fed wait until October? How easy would the choice be if you get both a bad payrolls print and a bad inflation print that month?

Better to acknowledge that the inflation threat is not as acute as initially feared, acknowledge that interest rate levels are restrictive, and acknowledge that there are vulnerabilities we do not wish to exacerbate. And resume the easing cycle now.

UK: Tax hikes are expected in autumn budget

The past week has been notable for UK gilts, with 30-year bond yields increasing by nearly 20 basis points on Wednesday, reflecting uncertainty surrounding Chancellor Rachel Reeves’s future and market expectations on looser fiscal policy. This development occurred amid criticism from government MPs regarding the current economic strategy, which prioritizes spending reductions over tax increases to bolster public finances.

In March, the government introduced welfare reforms meant to achieve £5 billion savings. However, following resistance from within its own party, these proposals were withdrawn on Tuesday. Consequently, the government must now identify alternative measures to secure the savings of £5 billion a year, in addition to covering a further £1.2 billion shortfall from the reversal of previous changes to winter fuel payments.

Mounting spending pressures have coincided with the release of the OBR's forecast evaluation report, which highlighted a consistent tendency toward optimism in medium-term growth projections since 2010. This pattern indicates that a downward revision of the trend growth rate is highly probable in the forthcoming Autumn budget. We have maintained for a long time that downward revisions to economic growth and net migration will remove any fiscal headroom.

Along with recent adverse movements in markets, it is likely that the government will be required to implement policy tightening measures amounting to at least £20 billion in the upcoming Budget to comply with fiscal rules, only maintaining minimal headroom. This calculation does not account for increases in defense spending announced at last week's NATO summit.

Market reactions suggest that additional government borrowing to address the large funding gap is unlikely. Consequently, the government’s deviation from the 2024 manifesto commitments on tax rates may become necessary. Extending the freeze on personal tax allowances and thresholds beyond 2027/28 now appears to be the most feasible option. Minor tax adjustments, such as increasing duties on gambling and alcohol or revisiting the 3% bank profit surcharge, may also be considered; however, these measures would generate only limited additional revenue.

BoE Governor Bailey, speaking at the Sintra conference, highlighted a weakening labor market but noted more evidence was needed to show its effect on nominal variables. He also indicated support for a gradual easing but mentioned the possibility of reconsidering if wage and price data weaken further. Wage growth is currently below the Bank of England's projections, while core services inflation continued to decline in May. A rate cut is likely in August, and the probability of another cut in September is increasing.

Australia: Consensus agrees with us

The market and consensus now fully expect a July rate cut, our forecast since May. Just last week we downgraded our Australia outlook, as we fear these measured rate cuts by the Reserve Bank of Australia (RBA) may not foster faster growth.

Aussie consumers, however, show optimism, as their own finances sentiment has remained largely stable, both compared with last year and also the next year, and notably stronger than views expressed by US consumers.

We expect this sentiment to improve further in the coming months, given mounting expectations on rate cuts. However, one cannot be confident with central banking forecasts. The economy might have a spring in its step as the easing cycle begins; we are already observing improving housing market conditions, as price, sentiment and asking rents have been trending up.

This is the primary reason why we still expect the terminal cash rate to be 3.10% this year, as the measured easing could be sufficient for the economy to find its rhythm.

Spotlight on next week

• Tough week for Japan, as it may be disappointed on a trade deal, with elections on the radar.
• The RBA to cut the cash rate by 25 bp.