US Federal Reserve reassesses rate expectations after weak retail sales

American consumers did something in July they hadn’t done in nine months: they pulled back. Retail and food services sales came in at $763.6 billion, a 0.6% decline from June, according to preliminary estimates from the US Census Bureau released on August 14. Markets had been expecting a modest increase. They got the opposite.

The miss was bad enough on its own. Paired with a University of Michigan consumer sentiment reading that cratered to 51.0 from 55.2, it painted a picture of an economy losing momentum at precisely the wrong time for hawks at the Federal Reserve.

Rate hike odds take a beating

A month ago, traders were pricing in roughly a coin-flip chance that the Fed would raise rates at its September FOMC meeting. That probability has now collapsed to somewhere between 22.5% and 31%.

The Fed has kept rates elevated for years to combat inflation that has stubbornly exceeded its 2% target for more than half a decade. Two-year Treasury yields dropped in response to the data, a textbook reaction when markets start pricing in a less aggressive central bank.

The retail sales report didn’t arrive in isolation. It followed weak nonfarm payroll and CPI readings that had already started to chip away at the tightening narrative.

Consumer sentiment joins the downturn

The Michigan sentiment index falling to 51.0 is worth pausing on. That’s a meaningful drop from the prior month’s 55.2, and readings below 60 have historically signaled genuine consumer unease rather than garden-variety pessimism.

Making matters more complicated for the Fed, year-ahead inflation expectations edged up to 4.3%. Consumers feel worse about the economy but still expect prices to keep climbing. Persistent inflation expectations argue for keeping rates high, or even raising them further. But deteriorating consumer spending and sentiment argue for caution.

What the spending slowdown means for markets

The immediate effect on fixed income markets was clear: lower yields and rising bond prices. If the Fed holds rates steady rather than hiking in September, the front end of the yield curve becomes considerably more predictable.

The September FOMC meeting is now roughly six weeks away. Between now and then, markets will get another jobs report, another CPI print, and additional consumer data that will either confirm July’s weakness or suggest it was a one-month anomaly.