GDP data shows US economy contracted for second quarter in a row. Markets react by further paring back Fed rate hike expectations. US rates fall sharply, US 10-year hits lowest level since April

Global bond rates have seen further big falls overnight after US Q2 GDP growth came in negative, putting the US into a ‘technical’ recession. The lower rates backdrop has supported equity markets, which have extended their post-FOMC rally.  Currency moves have been reasonably modest except for the JPY, which has seen a big appreciation (USD/JPY -1.6%) on the back of lower US Treasury rates. NZ rates continue to take their lead from offshore markets. The market has pared back RBNZ rate hike expectations and now sees a peak in the OCR below 4%.

US Q2 GDP growth came in weaker than the economist consensus, with the economy contracting at a 0.9% annualised rate in Q2 (+0.4% expected), the second straight quarter of negative growth.  While the negative Q1 growth figure was largely due to a big hit from net exports, there were genuine signs of a slowdown in domestic activity in the Q2 numbers.  Consumption slowed to a 1% annualised rate while business investment was broadly flat and residential investment slumped 14% off the back of the slowing housing market.

The two consecutive quarters of negative growth means the US now meets a common definition of a ‘technical recession’.  However, note that the US has its own recession dating committee (via the NBER) which looks at a broader range of indicators than just GDP, which is often revised, including employment and industrial production.  And there’s no chance of the NBER calling a recession over the first half of the year given employment growth was so strong.  Indeed, many economists expect the negative Q1 figure to subsequently be revised up.  The real recession risk lies ahead, as signalled by the recent inversion of the US yield curve.

The negative GDP print shouldn’t have been a shock given the Atlanta Fed’s nowcasting estimate (and almost a third of economists surveyed) has been pointing to this outcome.  But that hasn’t prevented a big market reaction.  US Treasury rates fell sharply after the release, with the 2-year rate down as much as 18bps at one stage, as the market pared back Fed rate hike expectations.  Rates have recovered off their intraday lows but are still by 10-12bps out to 10 years.  The US 10-year rate has broken the bottom of its recent trading range, falling to its lowest level since April at around 2.69%.  The market is now pricing less than 100bps of Fed hikes by the end of the year, which Chair Powell yesterday suggested was still a reasonable baseline, and around two rate cuts in 2023.

It has been a case of ‘bad news is good news’ for the equity market, with US stocks extending their post-FOMC rally.  The S&P500 is up by around 1.2% and the NASDAQ by about 1%, following yesterday’s chunky increases (+2.6% and +4.1% respectively).  The market’s assessment appears to be that the Fed will be slower to hike, and this has supported broader risk appetite and forward-looking growth expectations.  Industrial commodity prices are also stronger overnight, with copper up by around 1.6%, consistent with the market pricing a less pessimistic forward-looking growth outlook.

On the earnings front, Meta (formerly Facebook) announced weaker than expected results, with revenue falling compared to a year ago, partly on the back of a stronger USD, which has reduced foreign earnings.  In further evidence of the slowdown in global growth, the firm noted the “economic downturn” has affected demand for digital advertising.  Meta shares slumped 6.5%, although this hasn’t prevented broader gains in US stocks.  Tech heavyweights Amazon and Apple report after the bell this morning.

Ahead of the Eurozone figures tonight, German CPI came in much higher than expected, with headline inflation reaching its highest level in at least 30 years.  The EU harmonised measure of annual inflation hit 8.5%.  The market paid no attention, with German bond rates collapsing in response to the moves in the US.  The 2-year German rate was down 20bps on the session, to 0.25%, with the market now pricing little more than 100bps of additional hikes for the ECB this cycle.  Likewise, the EUR is down around 0.3% overnight, falling back below the 1.02 mark. The market appears more focused on the imminent European recession amidst restricted gas supply to the region.

The JPY has been the big mover in currency markets.   USD/JPY has fallen 1.5% over the past 24 hours, to a one-month low of 134.45, as the sharp fall in US Treasury rates narrows the interest rate differential between the US and Japan.  Currency moves elsewhere have been fairly subdued, with moves limited to +/-0.4%, although the USD has been generally stronger.  The NZD has outperformed the other commodity currencies and is slightly higher than where it was immediately after the FOMC meeting, at around 0.6275 this morning.  After hitting a 5-year low yesterday, the NZD/AUD cross is back above the 0.90 mark.

In other news, a revived US fiscal deal has been agreed with Senator Joe Manchin, providing funding for climate change and healthcare while also aiming to lower prescription drug prices.  It will be funded by a variety of measures, including a 15% minimum corporate tax rate, and is forecast to cut the deficit by $300b over 10 years (~1%/GDP). In a sign of the times, the substantially slimmed down version of Biden’s proposed Build Back Better bill has been relabelled the “Inflation Reduction Act”.  The bill still needs to win the support of the remaining Senate Democrats and get through the house to pass.  The market hasn’t paid much attention, given the small impact on the fiscal deficit and with attention fixed on the Fed.

Biden and Xi have spoken by phone overnight as tensions escalate ahead of senior Democrat Pelosi’s planned visit to Taiwan. According to the Chinese version of the call, Biden reiterated support for the US “one China” policy.  However, the Chinese readout didn’t call the discussion “constructive”, as it has done previously, suggesting tensions remain elevated.

In domestic news, the ANZ business survey for July painted an unsurprising picture of a struggling NZ economy but still elevated inflationary pressures.  Business activity remained at depressed levels (consistent with recessionary conditions, at face value) while residential investment intentions slumped to record lows, portending a major slowdown in building activity ahead.  In contrast, the inflation gauges remained at extremely elevated levels, consistent with inflation well above the RBNZ’s 1-3% target range.  Likewise, employment intentions are still consistent with positive employment growth and an ultra-low unemployment rate.  Separately, monthly filled-jobs data showed a 0.6% increase in jobs in June, pointing to upside risks to next week’s HLFS employment data and the possibility the unemployment rate could print below 3%.

The market paid little attention to the ANZ business survey, with all the focus on the Fed.  There was another big fall in short-term NZ rates yesterday, taking their lead the moves in US rates, with the 2-year swap rate down 7bps, to 3.87%.  The 2-year swap rate has fallen 20bps in the space of just eight days as the market has pared back RBNZ rate hike expectations (in-line with the global trend), with the peak in the cash rate now seen below 4%.  Like global curves, the NZ yield curve steepened, although the 2y10y swap curve remains deeply inverted, at -20bps.

There is a lot on the agenda in the session ahead.  Eurozone GDP is expected to show subdued quarterly growth of just 0.2% in Q2, although leading indicators suggest the region is heading towards negative growth in the coming quarters. Highlighting the stagflationary backdrop, European CPI is expected to reach a new record high of 8.7% y/y with core inflation nudging up to almost 4%.  In the US, the two key releases are the Employment Cost Index, the most comprehensive measure of US wage growth, and 5-10yr inflation expectations from the University of Michigan survey.  Inflation expectations unexpectedly fell to 2.8% in the preliminary survey release, but the results are sometimes revised when the final results come out.  The official Chinese PMIs are released over the weekend.