Market Insider

Weak services data raise big red flag on economy and pushes back Fed rate hike odds

An employee prepares a breakfast sandwich for a customer at a Dunkin Donuts Inc. restaurant in New York.
Victor J. Blue | Bloomberg | Getty Images

After a plunge in manufacturing activity, the much bigger services sector showed a surprise, massive slowdown in growth in August, raising new warnings on the economy.

The ISM non-manufacturing index fell to 51.4, the lowest level since February, 2010. The index reports on a much broader swath of the economy than the manufacturing report, and therefore is more concerning if it is signaling a new trend in weakness. The services sector represents about 70 percent of the U.S. economy.

Stocks lost ground and Treasury yields immediately fell, as investors jumped into the safety of bonds. Bond prices move inversely to yield. The 2-year yield, the one most sensitive to the Fed, tumbled to 0.74 percent from 0.79 percent.

Fed funds futures immediately reduced odds sharply of a September rate hike. They had been around 35 percent for September, but fell closer to 25 percent after ISM non-manufacturing report, according to Jefferies. July's ISM was 55.5 and economists had expected a reading of 55. Below 50 is a sing of contraction.

Last week, August's ISM manufacturing data came in at a stunning 49.4, the lowest since January. The two reports bookend Friday's disappointing employment report, where job growth fell to a slower pace of 150,000, 30,000 fewer than expected.

John Briggs, head of strategy at RBS, said the softness could be related to the worry about Brexit, the U.K. vote earlier in the summer to leave the European Union, and therefore, may be fleeting.

"We were always in the position of thinking the Fed doesn't go until December. This just hammers it home. The last two times (that) ISM fell below 52 percent, it was preceding a recession," said Briggs. He said the indicator, which is relatively new compared with the ISM manufacturing survey, fell below 52 in both 2001 and again in early 2008.

Amherst Pierpont economist Stephen Stanley said the services sector data may not be signaling anything beyond a temporarily soft spot, but it would discourage the Fed from hiking in September.

"...the new orders and production components were both between 51 and 52, also the worst results since early 2010. The employment figure slipped by less than a point to 50.7. The text of the report notes that most comments from respondents point to a slowing in business, though none of the individual comments that were included in the report seem consistent with much more than a summer lull," Stanley wrote in a note.

He said it remains to be seen how serious the ISM weakness becomes. "I am inclined to view it as more of a one-off than a rolling over of activity, but for those Fed officials who are having a difficult time deciding what to do at this month's meeting, all of the major August data out so far (auto sales, payrolls, both ISMs) have been noticeably weaker than expected. I'm not terribly worried about the fate of the economy, but I do feel even more comfortable today than I did a week ago calling for no Fed move in September," Stanley noted.

Tom Simons, chief money market economist at Jefferies, also said it could be just a one-month weak period but it's too soon to say.

"The thing that really stinks is this week is so light on data, there's not really anything to change the tone," he said. Simons also noted that Tuesday's other data, the August Fed Labor Market Condition Index (LMCI) fell by 0.7 points, its seventh decline in eight months.

Fed speakers will be the big events, starting with San Francisco Fed President John Williams Tuesday evening.

The next big data reports are Sept. 15 when retail sales and Producer Price Index are reported, as well as regional Fed surveys. The Consumer Price Index is reported Sept. 16.