Looking Through

Rate-cut hopes have ebbed and flowed with economic data, with the market now pricing in a greater than 90% chance of a rate cut as soon as September. This is a remarkable change from the just-over 50% odds placed on a September cut only a month ago.

So, what has changed? The July CPI report was relatively tame with a 0.2% monthly gain and a 2.7% year-over-year increase, which deflected concern that increases to tariff rates would manifest in meaningfully higher consumer prices. In addition, the July jobs report signaled potential weakening in the U.S. labor market, which has provided critical support to economic growth. While not flashing red at this point, the weak job gains, coupled with the significant downward revisions to the prior month’s data, will certainly be on the Fed’s radar. Finally, there is growing dissent at the Fed, with more FOMC members voicing concerns that monetary policy is too tight and that rate cuts are prudent.

We will hear more from Fed Chair Powell at Jackson Hole later this month. While we anticipate that Powell will stick to the “data dependent” messaging, it will be interesting to see how the chair navigates the tricky economic and political environment, both of which are influencing market expectations for future policy.

While consumer prices are not showing signs of tariff-related upward pressure, the producer price index (PPI) jumped by 0.9%, its biggest monthly gain in three years, representing a significant upside surprise relative to the expectation of a 0.2% increase. Year-over-year, producer prices accelerated by 3.3%, which, unfortunately, is a reversal of some of the disinflation we have seen throughout 2025. The increase in the PPI was relatively broad-based, with services prices rising a remarkable 1.1% — the largest gain since early 2022. However, much of the gain was driven by the volatile financial services component. Goods prices also rose, gaining 0.7% on the month. The core PPI, ex-food and energy, also came in above consensus with a 0.7% gain.

Financial markets, however, continue to look through any potential short-term distortions in inflation, focusing on the future path of monetary policy, which is anticipated to be easier (e.g., lower policy rate). Yields across the U.S. Treasury curve have moved meaningfully lower in August, with the 2- and 10-year Treasury yields having fallen 27 and 13 basis points, respectively. Interestingly, as shorter-term rates have fallen faster than longer-term bond yields, the yield curve — the difference between the 2- and 10-year Treasury yields — has steepened significantly and now sits at roughly 55 basis points. This represents the steepest curve since early 2022, before the Fed embarked on this tightening cycle.

Today’s yield curve reflects the growing market consensus that the Fed will restart the rate-cut cycle in September, and ultimately will cut the policy rate by 100 to125 basis points over the next year. It also shows the market’s longer-term concerns that inflation will remain elevated. Market strategists and economists alike watch the yield curve carefully, and we can look to history to tie changes in the yield curve to forthcoming economic conditions. Notably, the last few major yield curves steepenings of this nature — a so-called "bull steepening,” where short rates fall faster than long rates — preceded the start of recessions. This occurred in 2001, 2007 and 2019. While we are not calling for a recession, we remain cautious on the macro-outlook.

While the U.S. economy reflects resilience in the face of myriad challenges, China’s economy is not faring as well.  Recent data show disappointing retail sales. Perhaps more worrisome is the softness in industrial activity. Industrial production growth in China has slowed to a 5.7% year-over-year pace, which is significantly lower than the June data and a disappointment relative to consensus. Fixed asset investment — a key reflection of business confidence — also slowed, and residential housing investment dropped by 11%, even as housing prices continue to decline. With the meaningful risk of tariffs remaining in place, this weak data is yet another strong signal to policymakers that a more meaningful response is needed to stabilize the economy and improve the growth outlook.

All that said, and in another “the economy is not the market” proof point, Chinese equities are providing a tailwind to Emerging Market benchmarks, with the lion’s share of gains attributed to multiple expansion as investor optimism has improved. Emerging markets are outpacing U.S. equity markets this year with an over 20% gain against an S&P return of just under 11%.

The U.S. has seen a surge in tariff revenue so far in 2025, with Reuters reporting a four-fold increase in July customs duty collections year-over-year: July’s $27.7 billion inflow was up from only $7 billion in June of 2024. With aggregate data available only through June, first-half customs duties reached $108 billion, representing a near-doubling year-over-year. The acceleration in July puts the U.S. on pace for potentially $300 billion in annual customs revenue by year-end 2025. This puts tariff revenue at a much higher percentage of total federal inflows. However, even if we reach $300 billion in tariff revenue, that still represents only 5% of federal revenue and a fraction of the $1.6 trillion to $2 trillion deficit — billions against trillions.

Further, there is risk associated with the sharp increase in tariff rates. The first is slower growth, as tariffs may reduce trade volumes, investment and GDP growth. The second is that tariffs may set off another round of inflation as price increases are passed on to consumers. Third, in addition to a consumption headwind, higher inflation may influence monetary policy and cause interest rates to remain higher for longer, which raises the government’s debt servicing cost. And last, there remains the risk that our trading partners may impose their own retaliatory tariffs, which would hurt U.S. exports. These economic side effects have been well documented as risks by the Congressional Budget Office.