In the week just passed, the financial markets received a lot of new fundamental information from which to derive a sustainable trading direction. We saw the FOMC decision to increase policy rates by 75 basis points, which was largely in line with consensus. We also heard from Powell at the press conference that the Fed is cognizant of the risk of a recession. However, the risk of elevated inflation expectations far outweighs the risks of a slower economy. We also learned that real GDP during the second quarter contracted 0.9%. Now this is on top of the -1.6% print that we saw in Q1.
Recession?
Now we’ve seen two back-to-back quarters of negative GDP. That has typically been the rule of thumb for a recession. However, even at the press conference, Powell made it very clear that the US economy is not in a recession, given how low the unemployment rate is and other aspects of the economy that continue to show ongoing strength. That’s not untrue as GDP isn’t the only measure that matters, especially in the tangled mess of the pandemic economy. The National Bureau of Economic Research (NBER) has the final say on whether a period of economic decline is a recession, but a determination that can lag for months. I would like to remind everybody that since 1948, among all ten technical recessions, none of them was not a NBER recession. And there has been 2 out of 12 NBER recessions that didn’t experience two consecutive quarters of GDC slow down being 1960 and 2001.
The one caveat here is, if looking at the leading indicators, we continue to see disappointing consumer confidence numbers, a softer ISM Manufacturing PMI, and the upward pressure, albeit modestly, on initial jobless claims. Though Powell conceded that while the Fed does not intend to trigger a true recession and he sees a path forward that doesn’t involve a recession, that path has just gotten a lot narrower. The concern embedded in that assumption is that the Fed can tweak the unemployment rate higher without overshooting. Again, very difficult to engineer a soft landing and if history is any guide, the Fed is more likely than not to overshoot and trigger a meaningful recession sometime within the next 18 or 24 months.
Rebound of Duration and Risk Assets
As a result, it’s not surprising to see an increase in growth concerns manifest themselves in the form of lower Treasury yields, specifically a round of bullish re-steeping, especially once investors saw the negative GDP print for the second quarter. Despite the fact that Powell said 75 basis points is on the table for September, we’re now seeing the Fed Funds Futures Market, the front end of the coupon curve, and the overall shape of the rates landscape now reflect a much less aggressive presumed path of hikes from here. 10-year yields got to that 2.64% level, representing the lowest level that rates have been in several months. And more importantly, reinforcing the idea that the yield peaks for the cycle are in, and for tens, that is 3.50% and that any path to a 3.75% or 4% 10-year yield level is going to need to be revised or quite frankly, pushed forward to the next cycle. With the drawback in 10 year yields and anticipating the Fed’s hawkishness off the peak, we also saw a meaningful rebound in risk assets.
Where to go from here?
To me, the September question is still between 50 and 75 basis points, although admittedly, we do still have next week’s NFP data, two more CPI prints, and of course, August’s employment data as well that we’ll get in early September that will help refine the market’s collective expectation for just how quickly Powell will get to terminal. Though the market is pricing quickly reversing monetary policy with optimism, I would argue that the Fed will continue to maintain terminal for longer during this cycle than the market currently anticipates. One underlying motivation for that is that the Fed truly wants the balance sheet runoff to go as long as it can, and the Fed can’t cut rates while the balance sheet is unwinding in the background, certainly not if prior episodes are any guide. So this implies that once we get to 3.25%, that’s going to be static even if we start to see the unemployment rate overshoot the Fed’s expectations for this year and into 2023.
Nothing wrong with trading the rebound given that the market has digested the weaker than expected growth data. Waiting for the economy to bottom has historically been a mistake. Stocks have typically been up from their trough by the time the economy bottoms. The only question is, we should long, until when? 🙂
All About Macros 