US Growth Looks Stronger Than Expected, but Fiscal Policy Challenges Loom

The benign slowdown narrative has been put to the test as stronger-than-expected US business surveys have complicated expectations that the Federal Reserve could remain on hold for longer. The US services PMI rose from 54.6 to 56.8, its highest level since December 2024, instead of slipping to the expected 54.0. The composite PMI reached a four-year high of 56.0, a pace consistent with annualised third-quarter growth approaching 3%, compared with 1.5% in the second quarter.

The Federal Reserve's July minutes reinforced the more hawkish interpretation, with several policymakers prepared to raise rates immediately and many thinking tighter policy would eventually be necessary unless inflation moved convincingly towards 2%. Markets now assign roughly a 40% probability to a September increase and fully price a move by December, up from around 30% at the start of last week.

Bond markets are challenging fiscal policy as long-term sovereign yields reached multi-year to multi-decade highs across the US, Japan, and Europe. The US 30-year yield briefly touched 5.34%, its highest since 2007, while the ten-year approached 4.73%. Investors are demanding greater compensation for financing heavy government deficits at the same time that technology companies are issuing growing amounts of debt to fund AI infrastructure.

Higher long-term yields feed directly into mortgage and corporate financing costs while also lowering the present value investors are willing to place on future earnings. For markets, the long end of the curve is increasingly becoming a more important restraint on financial conditions than the Fed's next quarter-point decision.