Market Analysis

UBS Financial Services, in a note dated Monday, reaffirms its view that the U.S. economy is on course for a soft landing, although it emphasizes that the risk of a downturn remains significant.

A crucial factor in achieving a soft landing will be consumer spending. The Federal Reserve is anticipated to begin lowering interest rates soon, possibly as early as the upcoming meeting in September. These rate cuts could provide support to the economy during this uncertain period.

The U.S. labor market has experienced significant changes since the beginning of the year. "The unemployment rate has climbed swiftly, from 3.7% in January to 4.3% in July," UBS noted.

Historically, such an increase has been linked to economic downturns. However, UBS suggests this situation might be different, pointing out that while the labor market is not as overheated as it was two years ago, it remains robust by historical standards.

Weekly jobless claims, often considered a leading indicator of labor market health, have shown an upward trend. However, UBS advises caution in interpreting this data due to its inherent volatility and the challenges in seasonal adjustment.

While claims appear to be rising, the overall level remains low by historical standards, indicating that the labor market, though cooling, is not yet signaling a severe downturn.

Consumer spending is expected to play a pivotal role in the U.S. economic recovery. UBS notes that excess savings accumulated during the pandemic have largely been depleted, making continued income growth crucial for sustaining consumer spending.

Despite this, recent retail sales data for June and July have exceeded expectations, offering some reassurance that the economic recovery is still on track.

Nevertheless, the outlook remains uncertain. The U.S. government recently revised down its estimate of job growth for the 12 months ending in March by 818,000 jobs.

Additionally, the latest labor market report highlighted some softness in key income factors, such as wages and hours worked.

"Our base case remains a soft landing, but we have increased the probability of a hard landing to 25%, up from 20% previously," UBS stated.

Inflation continues to be a major concern for both the Federal Reserve and financial markets. According to UBS, recent inflation trends have shown some positive signs.

While inflation was relatively high earlier this year, more recent data indicates a slowdown. The headline inflation rate dropped to 2.9% year-over-year in July, the lowest since early 2021.

The decline in inflation has been driven by falling goods prices and moderating services inflation. However, UBS notes that shelter inflation, a key component of the Consumer Price Index (CPI), accelerated in July, rising by 0.4% month-over-month compared to 0.2% in June.

Shelter inflation is particularly important as it is the largest component of the CPI basket. Excluding shelter, inflation was just 1.7% year-over-year in July, suggesting that broader inflationary pressures are easing.

UBS remains confident that shelter inflation will eventually slow, especially given the modest increases in new rental leases since early 2023.

The Federal Reserve has indicated its readiness to begin cutting interest rates, with minutes from the July FOMC meeting and public comments from Fed officials suggesting that rate cuts could start at the September 18 meeting.

However, there is uncertainty about the pace and extent of these cuts.

UBS argues that the sharp rise in the unemployment rate, which the Fed had not anticipated, provides a strong incentive for the central bank to act swiftly.

Moreover, with real interest rates significantly above neutral, there is a case for an initial, substantial rate cut. UBS's base case is for a total of 100 basis points in rate cuts by the end of the year, which would likely require a 50-basis-point cut at one of the remaining FOMC meetings.

The Fed remains highly data-dependent, and UBS cautions that a wide range of outcomes is possible.

The upcoming September Federal Open Market Committee (FOMC) meeting is highly anticipated, as the Fed is expected to use the meeting's dot plot to signal its interest rate projections for the rest of the year.

This will provide investors with a clearer understanding of the Fed's monetary policy direction and its efforts to steer the economy toward a soft landing.

Paraphrasing text from "FX Street" all rights reserved by the original author.