Is a recession ahead?
As rate hikes impact the economy, data indicates growth has slowed. While it’s possible the Fed may still achieve a soft landing, bringing down inflation while maintaining economic growth, there’s a growing expectation among market participants that the US could slip into a recession in early 2023. Several factors make us inclined to believe this will be the case.
The inversion in the Treasury curve between the two- and 10-year yields that began on July 5, 2022, widened from 50 basis points (bps) at the beginning of November to 76 bps as of this writing. Historically, this type of inversion has been a good predictor of a contraction in economic activity. We interpret that widening inversion as a sign investors expect a recession.
Loss aversion is likely influencing investor behavior as well. The drawdown in financial assets and a teetering real estate market have eroded consumer confidence. The Conference Board Consumer Confidence Expectations Index reflected nine-year lows in July before rebounding. The latest reading in September was only 78.1, well below the 10-year average of 91.92. The wringing out of some economic excesses fueled by pandemic-era stimulus has no doubt exacerbated this lack of enthusiasm. By some accounts, the crypto markets have shed as much as $3 trillion in value, on top of losses in the bond markets of as much as $4.3 trillion.
All the above goes into our assessment that a 2023 recession is a distinct possibility. This would draw demand out of the system and significantly reduce inflationary pressures. The Fed will play a part in determining the depth and duration of a recession, which brings us to our next R: rates.
We know the Fed is committed to bringing inflation down. Chair Jerome Powell has staked the Fed’s credibility on achieving this goal and appears willing to accept a recession as a consequence of the Fed’s action. “No one knows if there is going to be a recession or not,” he said on November 2, “and if so, how bad that recession would be, and our job is to restore price stability so that we can have a strong labor market that benefits all over time, and that’s what we are going to do.”
Having increased the lower boundary of the funds rate from 0% to 3.75% in 11 months, it would be difficult to argue the Fed hasn’t been aggressive in raising rates. These hikes are having an effect. We have begun to see progress in the data, but the overall inflation rate remains uncomfortably high.
The markets expect the Fed to pivot in 2023 from a tightening monetary policy to a neutral stance. These expectations have been supported by the Fed’s dot plots, which indicate the end of the tightening cycle may be near. Indeed, Powell is now signaling as much. With the federal funds upper bound currently at 4% and the two-year Treasury yield around 4.5%, we now project a terminal rate of 5%. Market participants seem to have a consensus view on how interest rates might move, but the issue remains one of timing.
We’ve been impressed with the resilience of the economy in the face of a hawkish Fed. The labor markets remain robust, bank net interest margins are healthy, and consumers seem to be in good shape. While a recession is likely on the near horizon, it may be a mild one. Market participants appear to be focused on getting ahead of the Fed. Any signs of a disinflationary trend will likely result in a decline in yields out the curve. We saw an example of this when the 10-year Treasury yield fell 28 bps in a day following the October CPI report. The markets ignored the 6.3% annual increase in the core rate and focused instead on its decline from 6.6% in September. Against this background, if the Fed does cut rates in 2023, it may be more of a confirmation than an indication. This brings us to our third R: returns.