No Recession + Rate Cuts Equals Impossible

What You Missed

Yields across the maturity spectrum traded flat to lower over the course of a holiday shortened week, as key economic data framed the picture of a respectably strong economy amid an improving inflation outlook. The data helped to solidify the recent “good news is bad news” dynamic: a strong jobs market and falling inflation are indeed good for the economy but encourage the Fed to keep hiking rates, at least in the near term.

For the week, the 2, 5, 10 and 30-year US Treasury yields fell a respective 1, 12, 12 and 14 bps. Overall, the continued drop in yields reflects the financial market’s belief that short-term rates are indeed going higher in the near term, but the US economy won’t be able to sustain higher rates for long.

Elsewhere, global equities were higher on the week amid further evidence that US inflation continues to slow, while the price of a barrel of West Texas Intermediate crude oil added $4 to $78.75. The US dollar weakened, and Gold strengthened. The US 2-year vs. 10-year Treasury yield spread, a widely watched barometer of the likelihood of a looming recession, held near its most inverted level since the early 1980’s at -0.73%.

Hedging Costs Ease Further but Remain High

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its liquidity, continued its slow but steady ascent, ending the week at 4.63%, after peaking at an all-time high of 4.66% mid-week. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24) rose three basis points from this time last week, despite the fall in Treasury yields, to 4.14%.  The SOFR futures market continues to expect 3-month SOFR will peak in late spring 2023 – along with the Fed Funds rate – near 5.12%, followed by a gradual decline over the next three years as the Fed eventually eases.  Finally, interest rate volatility, a key driver of the cost of rate caps and other option-linked interest rate hedges, continued its recent descent, falling to levels last seen in mid-December.

US inflation pressures eased in December

Growth in consumer prices slowed for the sixth straight month in December, as evidenced by the Consumer Price Index (CPI) report, which showed a month-over-month decline of 0.1% from November and a more moderate year-over-year increase of 6.5%, down from November’s 7.1% pace.

Since CPI peaked at 9.1% in June, falling energy and goods prices have been the primary drivers of inflation’s slowing rate of ascent.  However, the rising costs of services, as opposed to goods, continue to keep inflation stubbornly high. Specifically, core services inflation, excluding shelter components, a purer measure favored by the Fed, ticked up to 7.4% year over year. That uptick, along with jobless claims data that suggest the jobs market remains exceptionally tight, kept markets on notice for more rate hikes around the corner.

Our take: With the headline inflation rate falling by 0.1% month over month in December, the CPI report provided positive inflation news for a third consecutive month, providing the Fed with the breathing room it needs to confidently downshift its future rate hikes to 25 basis points, beginning at its next meeting on February 1st. There’s a fly in the merlot though: Due to the ongoing price pressures for services – as opposed to the declining inflation dynamic in goods – the Fed clearly has more work to do and will keep hiking rates at least through March.

The consumer spending train maintained its momentum

The preliminary University of Michigan Consumer Sentiment Survey reading for January – a widely watched gauge of the future strength of the U.S. economy via consumers’ perceived confidence in the future – showed consumers’ outlook brightening at the start of the year, with the index rising to 64.6 from 59.7 prior, significantly above what was expected. The survey also showed short-term inflation expectations falling on the back of lower gasoline prices.

Our take: Despite forecasts of an impending economic slump, it seems that consumers aren’t quite ready to tighten their belts just yet due to easing price pressures and a robust jobs market. If the lower inflation, strong consumer confidence, strong jobs market triple whammy continues, it implies that any looming recession will be shallow and relatively short, with only certain segments of the economy in decline version the entire economy. Smart borrowers are watching these gauges intently, as they continue to assess how high the Fed will hike interest rates, and how long it will keep them there before cutting.

An inflation boogeyman is lurking in the shadows: China

China poses one of the largest threats to the declining inflation outlook.  Its recent, quick reopening from draconian COVID lockdowns is expected to significantly increase demand for goods and services, just as the Fed and other central banks are seemingly gaining control over inflation.

Without getting into the gory details, here are a couple of shocks from China’s re-opening that could re-ignite inflation in the rest of the world. 1) A severe supply shock occurs as a wave of new COVID infections spark a jump in absenteeism, causing Chinese firms to struggle to keep up production. For an example of this in the real world, take a look at Apple’s recent production issues. 2) As regular life in China eventually returns, there will be a positive demand shock that will spur global development and raise commodity prices.

To motivate you not to blow it off, remember that the first supply strains of the pandemic corresponded with China’s initial Covid lockdowns in early 2020. China’s domestic inflation data at the end of 2022 implies that delivery times will significantly lengthen, but probably not as much as what was seen at the start of the pandemic.

While unnerving, there are a couple factors that could soften the inflation blow to us here in the US. The global demand for made-in-China goods, such as personal electronics, has declined as the cautionary, COVID avoiding stay-at-home dynamic has waned. Additionally, US retail stores are sitting on sizable inventories, and are actively discounting them. Of course, time will tell, but ignore events in China at your risk.

What to Watch – Answering the Fed vs Markets Question

Last week’s data gives the Fed confidence to slow the pace of rate hikes to a more typical 25-basis-points. However, the yawning gap between what the Fed says it will do in the future and what markets think it will do still exists. Markets believe that recent inflation readings represent a durable, lasting decline, warranting rate cuts this year, whereas Fed officials have gone out of their way to counter that belief, implying that we won’t see rate cuts until 2024 at soonest, despite mounting risks of an economic recession this year. The billion-dollar question now? Who – the Fed or markets – will prove correct.

Sure, it’s possible the Fed may be underestimating the near-term downward pressure on prices, and this week’s data will help sort it out. The Producer Price Index (PPI – Wednesday) will likely reveal a strong decline in wholesale prices in December, which will then open the door for additional declines in core CPI in the coming months. Due to the continued easing of supply constraints, businesses are either attempting to reduce surplus inventories via discounting (Business Inventories, Wednesday) or are cautious about rebuilding them too quickly (Empire Manufacturing Index, Tuesday; Industrial Production, Wednesday). Adding on another layer, if oil price futures are correct, and it’s a stretch, headline CPI could fall to 2.5% as soon as June.

On the flip side, if the Fed cuts too soon, the strong jobs market, healthy wages, and China-driven, high commodity prices could cause inflation to remain stubbornly high, even with price pressures on rents – one of inflation’s recent drivers – gradually easing after mid-year. A floor under inflation could also be established by a boost in household spending (retail sales, Wednesday) when the fall in prices outpaces the slowdown in wage growth. All told, our gut tells us that there’s probably too many inflation-driving risks in play for the Fed to consider rate cuts anytime soon.

Big Picture: Why rate cuts and no recession are mutually exclusive.

Given the improving economic picture, it’s rational to argue that America’s economy will prove resilient and not fall into a recession this year. Separately, it’s equally logical to argue that the Fed could be cutting rates aggressively in the second half of the year. Unfortunately, both just won’t come to fruition simultaneously.

Taking a positive view, a resilient US consumer, who historically drives 75% of economic activity, single handedly holds up the US economy as inflation slumps to the Fed’s desired 2% target. In such a scenario, if the economy is holding up well without rate cuts, what’s the Fed’s motivation to cut? Other than a sudden fear of deflation, there isn’t one. How does that fear reconcile with an economy that’s chugging along nicely? It doesn’t.

Taking the opposite, negative view, should the US economy fall into a recession, the Fed would surely cut rates eventually to combat it.

But wait, there is a third scenario where rate cuts and no recession could occur simultaneously: It’s a world where the Fed cuts rates prematurely in anticipation of a growth slowdown that never comes. There’s no indication that the Fed would act as such, as it would probably reignite inflation and likely prove to be a policy mistake. As such, it seems that one must make a choice: be optimistic about the economy or believe in rate cuts. In the real world, you probably can’t have both.

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Source for all: Bloomberg Professional