Weekly focus – Lower inflation clears path for European rate cuts

This week saw a further escalation of the conflict in the Middle East, as Israel attacked Hezbollah in Lebanon and Iran launched missiles at Israel. There was little market reaction. Oil prices rose around two dollars per barrel but are still lower than last week, among other things held down by Saudi Arabia's wish to increase its production. It still seems most likely that the conflict will not evolve into attacks or blockades that will seriously affect energy production and exports, but there is clearly a risk of that happening.

Another factor that has contributed to relatively stable oil prices is weak demand growth in China, but it seems that authorities there are now fully committed to supporting the housing market and reigniting economic growth, and the strong rally in Chinese equities continued this week. We have also upgraded our expectations of growth in China. However, we are sceptical that the growth recovery will be strong enough to turn into a seriously inflationary force for the rest of the world and hence be a hindrance for expected rate cuts.

Euro area inflation declined in September to 1.8% y/y and is hence now below the 2% target. Perhaps more important, the month-to-month momentum in service prices dropped to just 0.14% by the ECB's calculation. There are some temporary factors at play and it is just one month, but we now judge the scale to have tipped in favour of an ECB rate cut at the next meeting on October 17, also because of weaker economic data (see Yield Outlook - Arguments for policy restrictiveness fade, 30 September). For example, although euro area unemployment remained at a record low in August, several indicators point to easing labour markets. Not least the reported labour demand from companies in the PMI surveys, which is usually a fairly good indicator of credit growth, has taken a turn downwards in the September data, but the euro area labour market also remains very fragmentated with more weakness to the North and strength to the South.

In the US, job growth of 254,000 in September was much stronger than expected. The unemployment rate declined to 4.1% from 4.2%, whereas average hourly earnings increased 0,4% compared to August, the second month with such a relatively strong increase. Together with other indicators of a relatively strong US labour market, this likely means that the next rate cut from the Fed will be 25bp rather than 50bp as last time. Note however that there will be one more job report before the rate decision in November, and as the September surprise illustrates, the job numbers are hard to predict and could surprise also in the other direction.

The most interesting data release scheduled for next week is US inflation data due on Thursday. The release is unlikely to change the market perception that inflation is mostly a solved problem and not a hindrance for rate cuts and that the labour market is the more important factor to watch, but how sticky service inflation is could well affect the Fed's thinking about the pace of rate cuts. With just a month to go before the election and the race being very close, US politics is also likely to draw attention - feel free to join our webinar on the fiscal, trade and market implications on 10.00 CET Thursday.

Download The Full Weekly Focus