Update Bonds: Fed Chief must choose between the red or blue pill?
The US economic narrative is resembling a scene from the movie The Matrix -- and the choice between the blue pill and the red pill has never been more pertinent. As Morpheus famously said in the film, choosing the red pill means venturing into the depths of reality (unveiling the truth of the economic landscape), while the blue pill means remaining in a comfortable illusion, such as regarding a soft economic landing.
Last Friday, there was a dramatic revision of job market data from the US Bureau of Labor Statistics (BLS). This revision may signal the end of the resilient US economic narrative, as the employment story was fundamentally altered by the revisions.
The immediate reaction in the interest yield market was telling: a stagflation move was priced-in, evidenced by a steepening yield curve (the short-end of the curve moved lower, and the long-end rose slightly). The critical question is: Are we transitioning from the possible dream of a no landing/soft landing scenario to a stagflation reality? The repercussions of the Trump tariff war may finally be surfacing, as Federal Reserve Chair Jerome Powell has hinted that the third quarter could reveal inflationary impacts.
Credit spreads widened slightly, particularly in the US high-yield sector. Simultaneously, the US dollar (USD) weakened, with the USD Index dropping by 2%. The weakening continued in the aftermath of President Donald Trump's decision to dismiss the head of the BLS following the release of the employment data. Furthermore, the resignation of a member of the Federal Reserve Board presents Trump with the opportunity to place a new individual within both the Federal Reserve and the BLS, potentially compromising their independence, which for fans of the Matrix is akin to Agent Smith's infiltration.
The upcoming release of US inflation data on 12 August will be significant. It may offer a respite from the stagflation narrative if the data shows disinflationary trends or fails to exceed expectations. This would provide the Fed Chair with the ideal platform at the Jackson Hole Conference (occurring a week after these data points are released) to prepare the market for a possible rate cut. Futures and swap markets are already pricing-in such a move for the September Federal Reserve policymakers meeting.
Until then, the market has a week or so to digest the narrative shift. The upcoming inflation data will be crucial to determining whether we are truly witnessing the end of one story and the beginning of another, i.e. whether there is a pivot back to a softer economic landing or we are taking a step closer to stagflation. The stakes are high; and like Neo in the Matrix, the Fed Chair must choose wisely as to what scenario lies ahead. At the same time, President Trump can always announce new tariffs (or anything else) if things do not go his way.