As the US dollar brushes off growing bets that the Fed is done hiking rates, the ISM non-manufacturing PMI will be watched on Wednesday (14:00 GMT) for fresh clues on the economy. The corresponding manufacturing PMI edged up slightly in August; will the services reading also improve, or will it renew concerns about a slowdown?

Not too hot, not too cold

All the indications are that the US economy is in a goldilocks situation right now – not too hot, not too cold. For risk assets such as equities, this is the best outcome investors could have hoped for as the danger of Fed overtightening dissipates along with fears of a deep recession.

For the dollar however, the net effect should be neutral as the pricing out of additional rate hikes would be offset by the pricing out of recession risks. This would then leave the greenback somewhat more exposed to non-US drivers and it goes some way in explaining why the currency has bounced back so strongly since mid-July.

America still fares better

With other central banks either likely to hike again against a much weaker economic backdrop but still high inflation, or have already paused, US assets look more favourable in comparison as stagflation is less of a concern. The big risk here, though, is that the US economy may not be cooling fast enough. According to the Atlanta Fed’s GDPNow forecast for third quarter growth, GDP is on track to expand by an annualized rate of 5.6%. Under normal circumstances, that would have been more than enough of a reason for the Fed to keep on hiking interest rates.

The inflation problem is not entirely gone either.  The decline in the various price metrics from current levels ranging from 3% to 5% all the way down to 2% could be a lot slower than how long it took for them to recede from peak levels of 5%-9%.

Will ISM services PMI point to a slowdown?

But other data have been less upbeat. The labour market in particular is showing increasing signs of an end to the hiring boom, while the manufacturing sector has been in the doldrums all year. As the Fed continues to strive towards striking a fine balance between fighting inflation and maintaining stable growth, the ISM’s non-manufacturing business survey will be a crucial barometer on what’s happening under the hood.

The ISM services PMI has been on a steady decline since late 2021 from the high of the post-pandemic recovery and in recent months, it’s been hovering slightly above the 50-neutral mark that separates expansion from contraction. The index dipped to 52.7 in July and is expected to have eased further in August to 52.5.

Prices paid index will be important

Traders will also be keeping a close eye on the subcomponents comprising new orders, employment and prices paid. New orders is a forward looking indicator of future output so any deterioration in this index would be worrisome. The employment index on the other hand has been somewhat inconsistent with the trend in the official payrolls figures.

However, it is the prices paid index that will be scrutinized the most as the Fed continues to fret about sticky services inflation. Whilst the manufacturing prices paid index has dropped sharply over the past year, the non-manufacturing equivalent has also fallen, but stayed above 50, suggesting that prices have kept on rising, albeit at a slower pace. It ticked up slightly to 56.8 in August, therefore, a further pickup would not be welcome by neither the Fed nor the markets.

Can the dollar extend its gains?

Investors still see about a 40% probability of the Fed hiking rates by 25 basis points one final time in November so a better-than-expected print in the ISM services PMI or its components would likely boost those odds. It would also add fuel to the dollar’s latest upswing. But while softer numbers could spark a negative correction for the greenback, the downside appears to be limited at the moment amid the support from higher Treasury yields as well as some safe-haven demand.