Federal Reserve Chair Jerome Powell warned further hot inflation prints and employment data could prompt a reversion to bigger interest rate hikes to tame persistent price increases. The hawkish tilt signals the limited impact of the Fed’s monetary tightening cycle to date and raises the prospect of a future US recession.
Inflation pressures reignited
At his semiannual testimony in the Senate on Tuesday (7 March 2023), Powell said interest rates are set to rise higher than anticipated as “inflationary pressures are running higher than expected” since the previous FOMC meeting. Markets interpreted Powell’s remarks as opening the door to a 50 basis point increase in interest rates at the upcoming FOMC meeting on 22 March “if the totality of the data were to indicate that faster tightening is warranted”. This conditionality appears to set a high bar for a return to a faster and longer tightening cycle.
February’s nonfarm payroll employment report rose by 311,000, above a market consensus of 225,000, while and the unemployment rate edged up to 3.6%, according to U.S. Bureau of Labor Statistics data. However, further evidence of the extremely tight US labour market was overshadowed by the widespread sell-off in the US in the US banking sector on Thursday (9 March), after Silicon Valley Bank (SVB), a small technology-focused lender, revealed on Wednesday (March 8) that it lost $1.8 billion following the sale of a portfolio of securities valued at $21 billion. SVB offloaded the securities in response to a decline in customer deposits. The losses prompted the bank to announce a $2.25 billion share sale to bolster its balance sheet. The losses in a niche venture capital-focussed bank on the West Coast triggered fears of similar unrealised securities portfolio losses across the broader global banking market. Panic spillover over into Europe on Friday (10 March). This event is the clearest sign yet how rising interest rates have put pressure on banks’ balance sheet – specifically in less liquid bond portfolios which cannot be sold quickly without taking loses. Banks have simultaneously suffered a sharp fall in the value of bond securities as interest rates have risen and post-pandemic deposit declines, depleting banks’ capital buffers.
This is a fast-evolving situation which we will examine in more detail in the coming weeks. Consequently, the hot US jobs report – which would normally increase probability of a 50 basis points rate hike – was met with the reverse. Markets are currently pricing in a near 60% probability of a 25 basis points increase, according to the CME FedWatch Tool, reversing from 70% in favour of a 50 basis points hike after Powell’s testimony on Tuesday.
Even a more dovish set of employment and inflation data to follow is currently expected to prompt an additional 25-basis points hike beyond March and May. In February the FOMC, the Fed’s interest rate-setting committee, increased the benchmark federal funds by 25 basis points to between 4.5% and 4.75%. Fed officials said the downshift provided time to better assess the impact of the 450 basis points of tightening since last March. It is the fastest tightening cycle in four decades in response to the most precipitous and persistent inflationary environment in equally as long.
Powell’s hawkish comments were the first since “revisions” in January’s CPI, PPI and PCE inflation reports were published. A key concern for Powell was re-acceleration in the personal consumption expenditures (PCE) price index, a closely watched inflation gauge by the Fed as it reveals underlying inflation trends excluding food and energy. The PCE price index nudged back up 10 basis points to 4.7% in January, which Powell said would require softening in labour markets to reverse. January’s blockbuster jobs report, published on 3 February, reported 517,000 jobs created, according to the U.S. Bureau of Labor Statistics, almost three-fold higher than the 185,000 market consensus forecast. Labour market resilience and easing energy prices are key pillars of strength for the US economy, which has so far helped delay – but not avert – a recession. On the flip side, extremely tight labour markets indicate that the Fed’s tightening cycle is still to be fully felt in the economy.
Equity-bond market divergence
Easing energy prices, a tight labour market and persistent price rises create conflicting macro signs that provide the ingredients for both a hard and a soft landing, reflected in the divergence of equity and bond markets. Equity investors appear to be looking past the negative externalities of an increasingly likely higher-for-longer interest rate environment (i.e. demand destruction, lower margins and higher debt servicing costs), which will ultimately force asset write-downs and increase default and refinancing risk. At the same time, bond markets are signalling that a recession is on the way. The yield curve inversion of US 2- and 10-year treasuries, when interest rates on short-term bonds are higher than for long-term bonds, is at its widest since 1981. It suggests that investors expect interest rates to rise in the near term and that higher borrowing costs will eventually hurt the economy, which may force the Fed into an eventual easing of monetary policy. Historically, the 2- and 10-year yield curve inversion is one of the best forward indicators of a recession, but it can take up to 18 months to manifest, implying a recession sometime between Q1 and Q2 2024. While the degree of inversion does not correlate with the severity of the recession to follow, at the least, bond market wisdom suggests the yield curve inversion is a powerful signal that a slowdown in the US economy – beyond what is evident today – is coming. Arguably, equity investors’ ‘glass half full’ outlook reflects the transmission lag in monetary policy on the economy. It is likely that the bulk of the pain caused by the Fed’s monetary tightening is still to come through later this year or early 2024.
Recession severity risk
A longer tightening cycle implies delays to an eventual pivot and reversal in the Fed funds rate. The US economy will likely have to absorb a more protracted higher interest rate regime, which adds delayed risk to the outlook for the economy.
According to CME Group data, the current market pricing for the terminal Fed funds rate moved higher following Powell’s remarks, to a range of 5.5%–5.75% by September. There is now a one-third probability that the terminal rate will reach between 5.75% and 6.0% by autumn. The risk for the Fed is that the central banks induce a more severe recession than necessary. If inflation remains persistent over the summer, prompting the FOMC to increase the terminal rate to 6%, the Fed will probably be tightening financial conditions into a weakening economy. In this scenario, a more severe recession may result. This scenario will stress test the Fed’s resolve to follow the data and meet its 2% long-term inflation target, potentially inducing an exaggerated recession into US presidential election year. An alternative scenario is that inflation does not persist so stubbornly, creating this trade-off. Much of the reinflation acceleration anxiety is due to China’s reopening (fuelling global inflationary pressures) and lower energy prices (spurring demand).
But the Fed will not pivot until the economy shows a clear downtrend in demand to ease price increases. The Fed can only achieve that through the blunt tool of interest rate hikes. Eventually, raising rates will curb investment, spending and hiring, but also at the cost of pushing up borrowing costs throughout the economy, causing unemployment to rise and core inflation to fall. Ultimately, labour markets must weaken, implying more pain for corporates and households.
Tighter financial conditions in the US economy may tempt cross-border global investors to allocate more capital to Europe and the UK, mediated by market and industry.
Next week, we will analyse how the UK Budget, along with the Bank of England's monetary policy, will impact the economy, the outlook for growth, and identify signs of distress and recovery by industry.
In the coming weeks, we will also explore the macro outlook for Europe and analyse how the European Central Bank's inflation battle is influencing the outlook for growth, interest rates, and the potential for corporate distress, bankruptcy and loan defaults.