FKU - Recession - But No Central Bank Rescue

2023-03-27 11:20:00 ET

Summary

• Central banks confront the growth-inflation trade-off, with the Federal Reserve seeing recession but no rate cuts. We agree - and prefer inflation-linked bonds.
• Bank stocks remained under pressure last week. The two-year U.S. Treasury yield slid further as the market priced in a series of Fed rate cuts.
• We’re watching inflation data on both sides of the Atlantic this week for further signs of it staying elevated, while monitoring the ongoing banking sector woes.

Transcript

The trade-off for central banks between crushing activity and living with persistently higher inflation is now front and center.

1) Financial stability vs. monetary policy objectives

We have long argued that economic damage and financial cracks would emerge from the fastest interest rate hikes since the 1980s.

In the past two weeks, major central banks clearly separated monetary policy from their efforts to deal with banking turmoil, and continued with further rate hikes.

2) A new phase of the inflation fight

The Federal Reserve, like other central banks, is now approaching a new phase of the inflation fight: stopping rate hikes as the evidence emerges of the economic damage caused.

But we do not see the Fed coming to the rescue with the repeated rate cuts the market is now pricing in. That’s the old playbook.

3) No rescue from recession

The Fed’s new forecasts show a recession this year, and yet, inflation is set to remain far above its 2% target.

That means the Fed won’t come to the rescue with rate cuts even as the economy contracts.

And we think inflation will prove even more persistent than the Fed expects.

This backdrop supports our move to go even more overweight inflation-linked bonds. We also prefer very short-term government paper, as we expect markets to price out rate cuts.

____________

The central bank trade-off between crushing activity or living with inflation is now impossible to ignore as economic damage and financial cracks emerge. That was evident in the Federal Reserve’s forecast of recession this year and sticky inflation in years to come. Central banks have clearly separated responses to the banking tumult and kept hiking rates. We see a new, more nuanced phase of curbing inflation ahead: less fighting but still no rate cuts. We favor inflation-linked bonds.

The chart shows the progression of the median Federal Open Market Committee projection for Q4 2023 U.S. real GDP growth and core PCE inflation year over year, from September 2021 through March 2023.

The progression of the Fed’s forecasts shows it has been repeatedly too optimistic on both growth and inflation - that’s the trade-off in action. See the chart. Its latest projections imply a recession in the months ahead, with growth stalling later in 2023 after a strong start to the year (red line). The Fed still doesn’t plan to cut rates because inflation is persistently above its 2% target. So, it is expecting to live with lingering inflation even with recession - it sees PCE inflation remaining above 3% at the end of 2023 (yellow line). It doesn’t see inflation falling back near its target until 2025. Even so, we think the Fed is underestimating how stubborn inflation is proving due to a tight labor market: Inflation could remain above its target for even longer than that if the recession is as mild as the Fed projects.

The Fed and other central banks made clear banking troubles would not stop them from further tightening. U.S. authorities acted swiftly to help stem contagion by protecting depositors from bank failures. By clearly separating financial and price stability goals and tools, major central banks carried on with rate hikes through the tumult. The Fed, European Central Bank and the Bank of England all did so. Even the Swiss National Bank lifted rates by 0.5% just days after facilitating a takeover of long-troubled Credit Suisse ( CS ). The bank troubles imply higher borrowing costs and tighter credit availability - and are part of the economic and financial damage we’ve long argued would come. That damage is now front and center - central banks are finally forced to confront it. We think this means they are set to enter the new phase of curbing inflation that we’ve been flagging. We see major central banks moving away from a “whatever it takes” approach, stopping their hikes and entering a more nuanced phase that’s less about a relentless fight against inflation but still one where they can’t cut rates.

No rate cuts this year

Markets have been quick to price in rate cuts as a result of the banking sector turmoil and the Fed signaling a coming pause. We don’t see rate cuts this year - that’s the old playbook when central banks would rush to rescue the economy as recession hit. Now they’re causing the recession to fight sticky inflation - and that makes rate cuts unlikely, in our view. Stocks have held up due to hopes for rates cuts that we don’t see coming. We think the Fed could only deliver the rate cuts priced in by markets if a more serious credit crunch took hold and caused an even deeper recession than we expect. We stay underweight developed market ((DM)) stocks because we don’t think they reflect the damage we see ahead.

Inflation is likely to prove even stickier than the Fed expects without a deep recession, in our view. The February U.S. CPI data confirmed our view that inflation is still not on track to settle at the Fed’s target. Current market pricing of U.S. and euro area inflation just above 2% on a 10-year horizon has edged lower recently - we think levels are likely to stay much higher than that. This is why we see value in inflation-linked bonds and prefer them to nominal peers. We also find very short-term government paper attractive for income given the potential for the market to price out rate cuts quickly. Strong money market demand provides additional support, in our view. We’re underweight long-term government bonds, as we see yields rising with investors demanding more compensation for holding them, or term premium, given persistent and volatile inflation.

Bottom line

We overweight inflation-linked bonds and like very short-term government paper for income. We stay nimble in the new regime of greater macro and market volatility - and are ready for opportunities as rate hike damage gets priced in.

Market backdrop

U.S. and Europe stocks steadied, even as bank and financial shares remained under pressure. Some European bank default protection costs jumped on the week. The U.S. two-year Treasury yield extended its historic drop and is down about 1.4 percentage points from a 16-year high hit earlier this month, causing a further steepening of the yield curve. The market is now pricing in about 1 percentage point of Fed rate cuts by the end of the year. We don’t think such cuts are coming.

We’re watching inflation on both sides of the Atlantic - including the Fed’s preferred PCE inflation gauge and flash inflation in the euro area. We expect services inflation to keep core inflation elevated. We’re watching U.S. consumer confidence as well for more signs of damage from still-rising rates, sticky inflation and banking sector troubles.

This post originally appeared on the iShares Market Insights.

For further details see: