The risk of a recession in the U.S. has grown, as the Fed appears un-swayed by recent softening of labour market and inflation data. Their reasoning is sound: the data is ambiguous. While the Treasury market appears to be pricing in recession, U.S. stocks do not. A jolt to the stock markets may come from weak first quarter earnings announcements and outlook statements, with particular attention being paid to this week’s announcements from the large banks on the outlook for loan growth.
The number of new jobless in the week to 8th April was higher than expected, at 239,000. This followed on from a JOLTS report a fortnight ago, showing a surprise fall in February new hires. At last, the U.S. labour market appears to be responding to the Fed’s year-long assault, of interest rate hikes and quantitative tightening (QT).
And the Fed has dovish voices. Minutes released last week of the Fed’s FOMC March meeting show some members urged for a pause in rate hikes, highlighting the effective tightening of monetary conditions caused by the recent bank crisis (a 25bp rate hike was voted through, nevertheless).
The problem for the Fed is that the economic data continues to be ambiguous. Therefore, the Fed is almost certainly going to raise rates once more at its next meeting on 3rd May. This will take the Fed target rate to 5%-5.25%.
The labour market is clearly weakening, but from a very strong level (and with unemployment still near multi-decade lows).
Although last week’s CPI data showed headline inflation weaken to 5%, its lowest level since May 2021, core inflation continued to rise -up 5.6% over the year and up 0.4% month-on-month, driven by shelter.
The same Fed minutes emphasises how hard it is to gauge the effect of the bank crisis on credit growth.
Fed governor Christopher Waller voiced the above concerns on Friday, in a speech widely interpreted as confirming a coming rate hike.
A clear downward trend in both pay growth and core unemployment appears to be a pre-request before any easing of monetary policy will be considered. Market expectations of two rate cuts by the year end look optimistic, bar an unforeseen event such as a systemic financial crisis. But then the market has consistently underestimated the persistence of inflation and of Fed rate hikes, over the last 18 months.
Arguments for a pause
The main argument against a May rate hike is the one published in the FOMC March minutes: that the central bank should pause and wait to see the impact of its sharp rise in interest rates over the last year. After all, the minutes are predicting a ‘mild recession’ starting later this year.
And should the risk of more things breaking be increased by more rate hikes? Particularly given that some credit tightening is indisputably in evidence, as regional and small U.S. banks pull back on riskier lending. Nervousness persists over the shadow bank sectors of real estate, private equity and hedge funds.
Jay Powell, chair of the Fed, has himself suggested that tighter financial conditions arising from the bank crisis may equate to a 25bp rate hike.
Furthermore, the market expectation of average inflation in the five-year period, 2028 to 2033, is firmly anchored. It is currently 2.29%, it has been around that level for the last two years*. A level that -one would have thought- the Fed would feel comfortable with, being only a little above its 2% target.
Increased risk of a not-so-mild recession
If the Fed does raise interest rates again in May, the risk must increase of recession. And not the mild recession that is expected by the FOMC, but something harder. This might be what it takes to reduce core inflation.
We must add to that the risk of recession triggered by more things breaking in the financial system, which may expose the Fed and Treasury’s boast of ‘mechanisms in place’ to be a fiction.
The long end of the Treasury yield has become more inverted over the last week, with 10yr yields now 0.56% below 2yrs (from a recent low of 0.38% 24th March). The inverted yield curve is a fairly reliable forecaster of recession.
The U.S. stock market has not heard the same message: the MSCI U.S. index of large and mid-sized stocks is up 8.1% since the start of the year, and 0.6% so far in April. As the first quarter earnings season progresses, analysts expect to see around an 8% fall in S&P500 earnings year-on-year.
This week, all eyes will be on banks’ first quarter earnings over the coming weeks. We expect the large ones to perform reasonably well, benefiting in part from deposit flight from small and mid-sized peers. The banks’ outlook for loan growth will be interpreted as an important leading economic indicator, along with more general statements regarding business and consumer confidence.
What can investors do?
Investors should brace themselves for the sound of more things breaking in the financial sector and the likelihood of recession during the second half of this year.
As we always say in these notes, the best defence against uncertain economic and financial conditions is to hold a diversified multi-asset portfolio. Financial history shows that, over the long term, this will give better returns relative to the amount of risk taken, than betting on just one asset class.
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*The 5-year, 5-year Forward Inflation Expectations Rate (T5YIFR), as of April 14, 2023. Source: St Louis Fed, FRED.
Minutes of the Federal Open Market Committee, March 21-22, 2023 (released April 12, 2023) available at: https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20230322.pdf
CPI Data (March 2023) available at: https://www.bls.gov/news.release/cpi.nr0.htm
Fed Governor Christopher J. Waller speech “Financial Stabilization and Macroeconomic Stabilization: Two Tools for Two Problems” April 14, 2023 available at: https://www.federalreserve.gov/newsevents/speech/waller20230414a.htm