Federal Reserve Chairman Jerome Powell left little doubt in the minds of Wall Street traders this week of his intention to aggressively attack the fastest inflation in forty years by essentially hinting his willingness to risk recession in order to do it.
Speaking yesterday to the yesterday to the National Association for Business Economics, Powell revied bets on faster — and deeper — rate hikes over the coming months as inflationary pressures continue to accelerate amid surging commodity prices and supply chain disruptions linked to China’s renewed Covid surge.
“The labor market is very strong, and inflation is much too high,” Powell said. “If we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
Bets on a 50 basis point hike at the Fed’s May meeting jumped to 68.3% following Powell’s speech, according to the CME Group’s FedWatch tool, while benchmark 10-year note yields climbed to 2.379% in early New York trading.
The only problem is, he might not be right.
Since his Hawkish pivot on rates last year, amid a concession that his prior assessment that inflation would be ‘transitory’ was fundamentally flawed, Powell has insisted that the U.S. economy is strong enough withstand a series of rates hikes, and encouraged his colleagues to follow him on a quicker path to ‘normalized’ interest rates between now and the end of the year.
To that end, FedWatch suggests we’re looking at a total of eight rate hikes over the course of 2022, up from a prior forecast of seven following Powell’s press conference last week in Washington.
“All signs are that this is a strong economy and, indeed, one that will be able to flourish, not to say withstand but certainly flourish, as well, in the face of less accommodative monetary policy,” Powell said last week. “We do feel the economy is very strong and well positioned to withstand tighter monetary policy.”
Curiously, however, the same bond market that has been goading Powell into his newly-hawkish stance isn’t as convinced that the economy can absorb seven more rate hikes without tipping into recession.
The yield gap between 2-year and 10-year note yields in early Tuesday trading is just 18.8 basis points, the lowest since the pandemic-era trough of April 2020.
The peculiar arithmetic of fixed-income investments basically makes short-dated bonds more sensitive to interest-rate changes.
So when short-term rates spike — and 2-year note yields have risen 1.4% so far this year — traders are anticipating higher Fed rates. But when, at the same time, they’re also worried about longer-term growth, they’ll still buy 10-year debt as a safety net, pushing prices higher and yields lower and thus “inverting” the curve.
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According to a study from the San Francisco Federal Reserve, an inverted yield curve has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment.
Okay, so, the bond market is throwing a bit of a tantrum — and not for the first time — but are we really at risk of recession when unemployment is firmly under 4% and supply chains are finally coming unstuck from their Covid-triggered torpor?
Well, the Atlanta Fed’s GDPNow suggest the economy is only growing at a 1.3% pace heading into the final week of the first quarter, while data from everything from retail sales to consumer sentiment is indicating signs of inflation fatigue and financial uncertainty in America’s consumer-powered economy.
Ian Shepherdson of Pantheon Macroeconomics, meanwhile, thinks growth might be even weaker than the GDPNow tool suggests, thanks in part to an adjustment in the inventory levels that boosted fourth quarter GDP to a 6.9% growth rate.
“Right now the inventory story means that we have to move down our central forecast for Q1 GDP growth to zero,” he said in a recent client note.
“To be clear, we think it very likely that zero Q1 growth and zero March payrolls would be temporary glitches, given the strength of final demand and the favorable fundamentals in both the household and corporate sectors,:” he added. “But with markets now expecting rates hikes at every Fed meeting, the risk of an over-reaction to soft readings in key numbers is real”.
In the meantime, nearly everything that’s added to inflationary pressures looks set to continue: oil prices are holding at multi-year highs, with WTI crude trading just under $110 a barrel; U.S. gasoline is within a whisker of its all-time peak, and currently pegged at $4.26 per gallon and there are more than 11 million unfilled positions in the domestic job market, adding to upward pressure on wages amid the so-called “Great Resignation”.
On the corporate side, borrowing costs will rise, pinching capital spending plans just as earnings growth is forecast to slow from around 32% over the three months ending in December to just 6.5% for the first quarter of this year, according to data from Refinitiv.
Oh, there’s also the small matter of a deadly and escalating conflict in Ukraine that’s both threatening growth prospects in Europe and sapping investor sentiment in markets all over the world.
Powell, however, remains firm in his view that the inflation fight must be waged:
“Our goal is to restore price stability while fostering another long expansion and sustaining a strong labor market,” he said Monday. “Soft, or at least soft-ish, landings have been relatively common (when) the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession.”
“In other cases, recessions chronologically followed the conclusion of a tightening cycle, but the recessions were not apparently due to excessive tightening of monetary policy,” he added.
That’s a thin line to walk with so many unknowns in place.