In an unusual turn of events, investors are suddenly acting as if bad news for the economy might also be bad news for financial markets. During yesterday’s session, evidence of rising unemployment and a deepening contraction in the US manufacturing sector helped compound the effects of a series of underwhelming earnings reports, triggering a plunge in major stock indices – and the selling looks set to continue at this morning’s open, as futures point to further losses.

Air seems to be coming out of the artificial intelligence bubble. Updates from the likes of Alphabet, Amazon, Apple, and Microsoft this week have highlighted growing revenue headwinds in key markets, but have also underscored the extent to which spectacularly-huge investments in data centres and artificial intelligence systems are failing to translate into near-term profits. The broader semiconductor sector is coming under pressure as earnings forecasts shrink, and a rotation is underway: rate-sensitive small caps and defensive cyclical stocks—real estate, utilities, financial services, health care, and energy—are outperforming “growth” segments.

The likelihood of a hard landing in the US is growing. Data out yesterday morning showed the number of Americans filing initial unemployment claims climbed to a one-year peak last week, while those continuing to receive unemployment benefits hit the highest levels since November 2021. The Institute for Supply Management’s measure of manufacturing-sector conditions missed market expectations in falling to 46.8 from 48.5 in June, while the employment sub-index plunged from 49.3 to 43.4 – exhibiting the sort of behaviour that has historically preceded broader economic downturns. This comes after a raft of other data releases showed labour market conditions beginning to cool, with hiring and quits rates, the job openings-to-unemployment ratio, and the Fed’s preferred wage growth indicator—the Employment Cost Index—all declining in relative synchrony.

Policy expectations are shifting. Futures curves are pointing to a much more aggressively front-loaded easing cycle than was imagined after the June Fed meeting, with overnight index swap markets assigning nearly 1-in-3 odds to a 50 basis-point move in September, and cuts expected at back-to-back meetings through the early part of next year. Two-year Treasuries are yielding the least since last May, and ten-year bonds are paying less than 3.95 percent, back to February’s lows.

Demand for funding currencies is rebounding. As investors bail out of high-risk asset classes and close out borrowing positions, both the yen and greenback are outperforming their rivals, with the Japanese currency soaring and the dollar reversing some of its recent weakness even as the domestic economic outlook darkens.

This morning’s non-farm payrolls report could prove pivotal. Hurricane Beryl’s impact has added an additional level of uncertainty in the construction and retail sectors, but markets think roughly 175,000 jobs were added in July, with average hourly earnings rising just 3.7 percent from a year earlier, marking the slowest pace in three years. The unemployment rate is seen holding near 4.1 percent, which would lift the three-month moving average to 0.47 percent above its 12-month low – perilously close to the 0.50-percent threshold that has historically signalled a recession. A positive surprise might trigger an upward reversal in yields, while a negative one—especially one in which the unemployment rate climbs materially—could see investors doubling down on hard landing bets, with defensive assets and the dollar outperforming alternatives through the early part of August.

From an economic insight perspective, next week should be a quiet one, with no first-tier data releases scheduled in the US, and no major speeches from Fed officials on the agenda. The Reserve Bank of Australia is expected to leave its cash rate target unchanged on Tuesday morning, with any hawkish impulses inhibited by recent softness in domestic growth, employment, and inflation conditions, and by a deterioration in the global growth outlook. Mexico’s central bank is seen holding benchmark borrowing costs at 11 percent, with a dovish bias leavened by elevated levels of imported inflation in recent data. And Canada might eke out a headline jobs gain in Friday’s Labour Force Survey, but the unemployment is likely to continue grinding higher as the population expands. With labour market conditions adding to growing economic slack, the Bank of Canada should be safe in downplaying upside inflation risks as it delivers another cut in September.