by Paul Hoffmeister, Chief Economist
The economy is at a tipping point facing recession.
In 2000, 2008 and 2019 when the yield curve inverted like this, the Fed stopped raising rates, but recession still followed. This time, the outlook is more ominous, as the Fed plans to carry on raising rates aggressively.
We continue to believe that things will get worse before they get better.
Last Wednesday, the Federal Reserve raised the fed funds rate 75 basis points to a target range of 3.75-4.00%. It was the Fed’s fourth consecutive rate increase of that size. The FOMC written statement that afternoon indicated that officials would soon slow down the increases, sparking a rally in equities. But soon thereafter, Chairman Powell emphasized that it was “premature to think about pausing.” Markets weren’t pleased, and stocks turned lower, leaving the S&P 500 down 2.5% for the day.
Powell acknowledged that the window for a soft landing that would avoid pushing the economy into recession had “narrowed.” Then, on Friday, employment data from the Bureau of Labor Statistics was a mixed bag as it showed some strength and some weakness. The economy added more than 260,000 jobs in October, although the unemployment rate had jumped from 3.5% to 3.7%.
This seems to be hardly enough labor market weakness to persuade Fed officials to stop their current campaign. Yesterday, former New York Fed President Bill Dudley went so far as to say that the Fed “hasn’t accomplished anything” in loosening the labor market.
The Fed’s recent policy pronouncement and economic data reaffirm our view that things will get worse before they get better. With headline inflation near 8% and unemployment less than 4%, inflation is the primary concern between the Fed’s two mandates, which are to maximize employment and minimize inflation. As a result, the Fed is telling us that it must raise interest rates even further to slow the economy in order to reduce overall demand and ultimately prices.
It's important to note as well that Fed officials also do not want to see exuberant financial markets. For example, in May, Powell said, “It’s good to see financial markets reacting in advance based on the way we’re speaking about the economy, and the consequence I mentioned is that financial conditions overall have tightened significantly… That’s what we need.”
Maya Angelou famously said, “If someone shows you who they are, then believe them the first time.” We are taking the Fed at face value and expect a recession and challenged financial markets during the next year.
On October 26th, the spread between the 3-month T-bill and 10-year Treasury inverted for the first time since 2019. An inversion of this segment of the yield curve is a well-known, leading indicator of a potential recession, including the last three in 2001, 2008 and 2020. The New York Federal Reserve, for its part, estimates that the probability of recession during the next year is 23%. Indeed, given the inversion of the Treasury curve today, Jerome Powell’s acknowledgement of the narrowing window for a soft-landing makes sense.
Notably, during the last 30 years when this spread went negative, the Federal Reserve did not proceed with additional rate increases. But this is not the case today. Fed officials are telegraphing the possibility of another 100 basis points of increases in the coming months.
Adding to our worry is the fact that the Fed is engineering the fastest interest rate hiking campaign of the last 30 years, and with it, the fastest flattening and inversion of the Treasury curve.
As we see it, the economy is now at the tipping point facing recession; and the Fed is going to keep strangling it.
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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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