Investors Should Keep Recession in Back of Mind

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Sam Lau, portfolio manager for DoubleLine Capital.

When thinking about the Fed shift in monetary policy, we expect interest rate volatility to continue in the months ahead as the Fed potentially embarks upon a policy-tightening program that would be the most aggressive since Volcker hiked rates to battle inflation back in the late 1970s.

The catalyst for the current round of tightening is the same with consumer inflation baskets as of the last print in March 31, 2022. Those are at 40-year highs. And that spooked the Fed into pivoting towards an aggressively tighter monetary policy. And while we may be near the top in this recent round of inflationary pressure, we’re likely to remain well above the Fed’s target inflation rate of 2% on their favourite measure, the core PCE, for a number of years yet. And that’s what has the Fed worried.

What gives the Fed optimism, however, to start hiking rates and unwinding the balance sheet is the strength of the U.S. economy and its labour market. Economists forecast for real GDP in 2022 is currently just over 3% on that annual basis, which is in the upper end of the range for growth going back to the global financial crisis.

As for the labour market, practically every economic data point that’s related to the labour market suggests strength. The headline unemployment rate is at 3.6%, and that’s the second lowest print going back to the 1970s. Employee wages are higher too with the Atlanta Fed’s Wage Growth measure at its historical high going back to the late 1990s. So with this, the Fed thinks the U.S. labour market is resilient enough to support the economy as it looks to dampen consumer inflation without sending the U.S. economy into a recession.

And the Fed has offered us a glimpse into the path of hikes and quantitative tightening. And by all indications, it looks like they’re planning for a much more aggressive approach than the last Fed tightening cycle that we had back in 2015. The Fed is going old school and it looks like they will raise the target Fed funds rate by 50 basis points at the next two FOMC meetings versus the 25 basis point rate hikes that many of us have become accustomed to.

The bond market right now is pricing in the federal funds target rate of 2.75%, on the upper bound of the range by year end. And this is versus where we were at the beginning of the year at just 25 basis points, again on that upper bound. So it’s an equivalent of 250 basis points of rate hikes in the course of the next 10 months.

For context, the last Fed hiking cycle began with a 25 basis point hike in December of 2015. We had another 25 basis point hike 12 months later in December of 2016, so a full year later. And then that was followed by three quarter-point hikes in 2017 and an additional four 25 basis point rate hikes in 2018. That got us to a target rate on the upper bound of 2.5%, so less than the 2.75 that the market’s expecting today. But it took three years to get to that lower target rate in that cycle versus what the market is pricing in this time to come in at under 10 months.

So on top of this fast and furious rate hike cycle that the market is expecting, the Fed has indicated that it could reduce the balance sheet holdings at almost double the pace of the last round of the balance sheet unwind. So this time around, we’re expecting a much more aggressive rate hike cycle coupled with a potentially faster and larger unwind to the balance sheet to fight the inflation that we haven’t seen in over four decades.

So that brings up the question of whether or not the Fed can orchestrate a soft economic landing. And to do so, let’s take a look at the track record. If one were to define the soft economic landing as one where the Fed hiking policy doesn’t lead to an economic recession let’s say within six quarters after their last hike, that would be a place to start in terms of defining that soft landing.

So going back to 1971, one can see that the Fed has had nine rate hike cycles. And of those nine, seven of them eventually led to an economic recession. So the Fed has successfully avoided recession two out of nine times. So I think my answer to can the Fed achieve a soft landing is maybe, but it just doesn’t look very promising. But please don’t get me wrong here, I’m not calling for a recession in the U.S. right now. And it’s still fairly early yet. The Fed has only begun just taking those steps that typically lead to an economic recession.

But if you’re to look at these charts for the data that I’ve been referencing, if you look at those charts under a microscope, you’ll see that recessions generally don’t occur during the actual Fed rate hikes. It actually doesn’t incur until the Fed reverses course and begins to cut rates. And that’s on the back of them realizing that the economy can no longer absorb those higher rates. But what I am saying is that perhaps recession should be in the back of your mind for those of you investors as you consider your portfolio allocations and assess how they may perform in a slowing economy.