Because the entire tightening cycle is already priced in, a recession is likely to come early


Equity markets were mostly up over the week, rebounding from clearly oversold conditions. But all the major indexes are still below their peaks, by more than 5% for the Dow Jones and the S&P 500, by more than 10% for the Nasdaq, a tech heavyweight, and by almost 15% for the Russell. 2000, more representative. Nonetheless, as equity markets rose, bond markets went in the opposite direction as an increasingly hawkish Fed drove up yields (more so on the short end of the yield curve) and prices at the end of the yield curve. decrease. The yield over the 10 years. The T-Note, from which mortgage rates are calculated, rose from 2.15% on March 18 to 2.49% at the close of business on Friday March 25, an increase of 34 basis points (bps) (c i.e. +0.34 percentage point) . At the turn of the year, this yield was 1.50%, an increase of nearly 100 basis points.

The 2 year old. The yield on T-Notes closed at 2.28% on Friday, down from 1.94% a week earlier and 0.73% on the last trading day of last year, up 155 basis points. The 10-2 spread (the difference between the yields of 10-year and 2-year T-Notes) is now only 20 basis points; when this reverses (i.e. the 2-year yield becomes higher than the 10-year yield), historically this has almost always presaged a recession.

The 5 year old. The T-Note also rose dramatically last week (2.39% to 2.58%) and it is reversed at the 10-year. T-Note, which, as noted above, closed at 2.49% on March 25. And, if you look at the shape of the yield curve (as shown in the chart at the top of this blog), it’s flat as a pancake, another indicator of an impending recession.

Most of the rise in yields is due to continued hawkish rhetoric from current Federal Reserve governors. There are now five such governors backing a 50 basis point rate hike at the next Fed meeting (May). As a result, fixed income markets have priced the odds of such action at 70%.

Is this time different? Answer: Yes

It is very risky to say that “this time is different”, because it almost never is. But, as we show below, there are very big differences between this cycle of Fed tightening and that of the 1980s (the Volcker era) when inflation was as big an issue as it is today. Before showing how it’s different, let’s first talk about the nature of this inflation.

The new data tells us that the economies of the United States and developed countries are slowing down. The Fed, now apparently politicized, must give the impression that it is fighting inflation; thus, warmongering discourse. Fed Chairman Powell insists the economy is strong and has called former Fed Chairman Paul Volcker’s hawkish policies of the 1980s heroic deeds.

The following graph, however, shows the relationship between inflation (CPI) and the price of oil. Note the strong correlation between the two. In the 1970s and 1980s, it was OPEC and the price of oil that were responsible for much of the inflation. Look to the right for today’s culprit. And in the 1980s, it was the drop in oil as well as the Fed that suppressed inflation.

Question: Can the Fed fight inflation by lowering the price of oil? Answer: No. It can only reduce inflation by raising interest rates and reducing demand. However, we see that the economy is already slowing down. The latest GDPNow forecast from the Fed’s own Reserve Bank of Atlanta is now at 0.9% for the second quarter (as of March 24). We note that there is not much time left in the quarter for a significant increase in this forecast. And let’s not forget that two-thirds of Q1 was pre-Russia/Ukraine (R/U).

At its March meeting, the latest data available to the Fed was for February, i.e. before R/U. It seems to us that President Powell’s vision of a “strong economy” and a “tight labor market” is based on both pre-R/U data and wishful thinking (fairy tale) or , more likely, political pressure. The fact is that the Fed, at its March meeting, lowered its GDP forecast for 2022 from a ridiculous 4.0% to a still unimaginable 2.8% (see our Forbes blog “A Hawkish Fed With A Fairytale Forecast”).

So what’s different?

There is a real difference between the Fed of today and that of the Paul Volcker era. This difference is that today’s Fed announces its intentions in advance. Before Ben Bernanke was Fed Chairman (2006-2014), the Fed never announced its actions in advance. Dot-plots (forecasts for Fed Funds from FOMC members released quarterly) have now become the bible of the bond market despite a poor balance sheet (the midpoint has a 37% correlation with the actual Fed Funds rate resulting according to Economist David Rosenberg). These began in 2012 under the Bernanke era. When Alan Greenspan was Fed Chairman (1987-2006), there were no post-meeting statements or press conferences. The markets didn’t know what the Fed had decided until the Fed acted. At that time, market gurus tried to gauge what the Fed was doing by non-market factors, for example, the thickness of Chairman Greenspan’s briefcase (we won’t tell you!).

Today’s Fed just stopped QE (Quantitative Easing, ie adding bonds to its portfolio) and only raised the Fed Funds rate by 25 bps; so, they just started the tightening process. But, unlike the Volcker era, markets, via the yield curve, have already fully priced in the full tightening cycle via the poorly correlated dot chart. It’s as if the Fed is already where the dot plot forecast would be in 2024! This is one to two years earlier than what happened under the Volcker era.

So the markets are significantly ahead of the Fed (i.e. they have completely tightened for them) and as a result we believe an economic downturn will occur much faster than in the past. . While history says it takes a year or more from the start of a Fed tightening cycle to a recession, we believe that this time the recession will happen much sooner, perhaps six years from now. months or less.

Emerging data

  • The price of gasoline. The chart says it all. Note that gas prices were already on the rise before R/U. From under $2.00/gallon in 2020, they were around $3.50/gallon before UK. On Monday, March 21, less than a month after the invasion, the average regular price was nearly $1 a gallon ($4.34) higher. And, if you live in California, it’s even higher than that ($5.84/gallon in Los Angeles). (Possibly even higher today as these prices are a week old as of this writing.)
  • Farm prices are up 24% in the US Y/Y (and farm income is up 44%). On the open market, this will lead to more plantings, even with rising costs and a shortage of fertilizer. The resulting spike in food prices is having a negative impact on US household budgets.
  • Housing: With rising interest rates, we are already seeing a negative impact on the housing market. New home sales fell -6.2% YoY in February (ahead of UK and the meteoric rise in rates over the past two weeks), and pending home sales fell -4, 1% over one month in February and 5.4% over one year. (again, pre-R/U). And, look at the table on mortgage refis. (This is where a lot of cash is made available to US households).
  • The Mortgage Bankers’ Association’s latest weekly mortgage approval index fell -8.1% and is now down -39% year on year. Indeed, mortgage rates are now above 4.5% (they were below 3% a year ago). Again, due to the Fed’s pre-announcement policy, markets did in weeks what previously took many months, months in which the Fed could change policy if needed.
  • European economies appear to be experiencing similar characteristics to the United States with respect to the timing of recession. In Germany, Italy, Spain and the UK, consumer confidence surveys are collapsing and their increases in food and energy prices appear to be similar to what is happening in the US. And this data is all pre-R/U.
  • Real personal disposable income is down (see chart).
  • The job picture is now starting to cool in the United States. The chart shows weakness in both the Conference Board’s latest job availability measure and that of the National Federation of Independent Business.

The shocks

The economy has suffered the following shocks over the past two years:

  • Pandemic: the government closes businesses.
  • Tax: Free money in 2020 and 2021; now none. This is called the “fiscal drag” because households do not have this extra free money to spend.
  • Interest rate shock: In less than 30 days, markets have entered a full tightening cycle. The flat yield curve is a reliable historical barometer of an impending recession.
  • Food and Energy Shock: There will be ongoing repercussions from the R/U invasion.
  • And the biggest shock: unlike past experiences of high inflation, today’s bond markets have priced in a whole one-to-two-year Fed tightening cycle and an already shocked and depressed economy within days. slow-down. The interest rate shock will accelerate the economic slowdown and trigger what we believe is an inevitable recession, and much sooner than markets currently expect. The question is: will the Fed recognize this soon and reverse its hawkish policy?

Final Thoughts

We believe the current Fed pre-announcement policy is deeply flawed and, in the current economy, will only add to recessionary pressures. The current exaggerated hike in interest rates by the markets is slowing already anemic growth and is based on deeply flawed Fed point forecasts. We believe that these most recent dashed forecasts were intended more to show resolution than to be predictors. According to Rosenberg Research, the Fed’s GDP track record is only 17% accurate, while the median accuracy of the dot plot is only 37%.

Rather, we think the Fed should discuss and forecast only its possible actions in the short term (say until the next meeting). While the Fed insists that every decision it makes depends on the data, such a restriction of its forecast would actually allow market forces, not a hypothetical dot chart, to determine the height and shape of the curve. rates.

(Joshua Barone contributed to this blog)


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