TPHD - The Fed Sees More Rate Hikes As The Market Bets On Recession

2023-03-23 12:46:24 ET

Summary

• The Fed sees more hikes this year and no rate cuts.
• The bond market appears to be thinking a recession is around the corner.
• Only one will be right, neither are good for stocks.

You were mistaken if you thought the Fed was finished raising rates in 2023. At its most recent meeting, the Fed raised rates by 25 bps and indicated via its dot plot that another hike was forthcoming, with no rate cuts projected for 2023. This was not what the market had hoped for, as it had priced in about three rate cuts and a lower terminal rate for 2023.

It also appears that the Fed may have wanted to signal even more rate hikes in the future but chose to wait and see how conditions develop in the aftermath of the Silicon Valley Bank failure. If the bank's impact on the US economy proves to be minimal, there's a good chance that further hikes will follow.

A Major Disagreement

The bond market and the Fed are not in agreement, with the market anticipating rates falling to approximately 4.20% by December 2023, while the Fed predicts rates to be at 5.1%. Additionally, the Fed has revised its forecast for 2024 Fed funds rates upward from 4.1% to 4.3%, indicating fewer rate cuts next year.

None of this was expected by the market, and even after the meeting, Fed funds futures declined, trading at 4.2% as of today for December 2023, with rates expected to be around 2.9% by December 2024.

On top of this, the Fed sees inflation running hotter, with projections for core PCE inflation rising from 3.5% to 3.6% by the end of 2023.

A Recession Is Imminent

The bond market currently appears to be convinced that the Fed's aggressive monetary policy tightening will cause a recession. This view is based on the belief that this tightening cycle has created stress in the banking sector, leading to further tightening of lending standards and ultimately sinking the economy.

This is particularly evident in the yield curve, which remains profoundly inverted and now seems to suggest that a recession will occur before the end of 2023. The 10-year minus 2-year 18-month forward curve has moved above 0 and is trading at a positive 18 bps.

This is the third time over the past year that the curve has moved above 0. It is also very close to surpassing the highs seen in January.

If the 18-month forward yield curve continues to steepen, it could pose a significant problem for both the Fed and the equity market. The last two times this occurred, it signaled an impending recession. Based on the available data, the issue appears not necessarily when the yield curve starts to steepen but rather when it does so rapidly, as this has historically preceded a recession.

In addition to signaling a recession, a rapidly-steepening yield curve has historically marked the top of the equity market, serving as a potential pivot point for equities to turn lower. If the curve continues to steepen quickly, it will further suggest the likelihood of a recession in the next few months.

Fed Sees Robust Data

The available data do not suggest an impending recession, which explains why the Fed and the market are at odds. According to the Atlanta Fed's GDPNow model, the first quarter GDP growth rate is projected to be 3.2%. The model also projects a PCE inflation rate of 5.02% in the first quarter, which would result in an estimated 8% nominal growth rate. This forecast does not indicate a recession and reinforces that inflation remains a pressing concern.

The market and Fed disagreement centers around the economy's strength. While the Fed believes the data indicates the economy remains strong, the market assumes a recession is imminent.

If the Fed is correct, it will continue to raise rates and maintain a restrictive policy stance for an extended period, assuming no further banking sector fallout. If the bond market's predictions come to pass, the Fed is likely finished raising rates, shifting to aggressive rate cuts in response to the impending recession.

In either scenario, risk assets will likely be challenging to own, as higher rates will constrain valuations and limit potential stock market gains. Alternatively, a recession would significantly impact corporate earnings and depress stock prices.

Given the risk/reward dynamics, it seems like a game of choosing your own poison.

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