by Paul Hoffmeister, Chief Economist
Fed Governor Waller’s expectation that unemployment will increase to 4% or more suggests to us that a Fed-induced recession is inevitable.
Economic data do not warrant a change of course anytime soon by Fed officials.
We expect more economic and financial pain..
The most important macro variable of 2022 is arguably the Federal Reserve’s interest-rate hiking campaign. The federal funds rate target stands at 1.50-1.75% today, compared to nearly zero percent between March 2020 and March 2022. And there appear to be much higher rates to come. The fed funds futures market currently predicts that the most likely scenario is for the overnight rate to be somewhere around 3.50% by year-end. This means the FOMC has four more meetings to raise rates by nearly 200 basis points.
The pain in stock and bond markets is obvious this year. Equity indices such as the S&P 500 and Nasdaq Composite are down more than 15% and 25%, respectively; and the Bloomberg Aggregate U.S. Bond Index has fallen more than 10%. Optimists are hoping that the Fed will back away from its hawkishness sooner rather than later, and give relief to stocks and bonds.
Indeed, a Fed relief rally could be powerful. The most recent relief rally occurred during the first half of 2019 when the Fed backed away from the hawkish rhetoric that roiled markets at the end of 2018. The S&P 500 and Bloomberg Bond Index rallied nearly 20% and 9%, respectively, during the first six months of 2019.
If we go deeper into history to when the Fed was aggressively fighting inflation -- during the early 1980s under Chairman Volcker -- the end of that tightening campaign occurred in August 1982. The relief in markets led to a nearly 40% rally in the S&P 500 into the end of that year.
Without question, the hope that the Fed will soon back off is enticing for investors given the gains that were catalyzed when the Fed shifted policy course in the past. Unfortunately, it doesn’t appear that the Fed is close to shifting anytime soon.
The CPI rose 8.6% year-over-year as of May, and is expected by many to register an 8.7% annual increase for June. That data will be released this week. Furthermore, employment data released last week showed the national unemployment rate remained at 3.6%; no change from the prior month and nearly the same job market strength the economy experienced before the Covid outbreak over two years ago. In sum, inflation is rising at a nearly 40-year high and the job market is nearly the strongest in history.
In the eyes of monetary policy technocrats, this isn’t an economic scenario that calls for dovishness. Instead, it gives the Fed more room to fight inflation and “vigilance” in using the blunt tool of high interest rates to slow growth to dampen the demand for goods and services (i.e. economic growth) and therefore reduce the price pressures in the economy.
All this suggests that there is more pain to come, economically and/or financially. Federal Reserve Governor Chris Waller said last month that moving rates quickly to a neutral level and into restrictive territory is necessary to slow demand and reduce inflation. He added that he foresees the unemployment rate rising to 4%-4.25%. In our view, Waller’s forecast basically suggests that the Fed is going to push the economy into recession.
For unemployment to rise from 3.6% today to more than 4%, it would most likely require a Fed-engineered recession. This is based on the Sahm Rule, which as discussed last month posits that recessions have in the past occurred whenever the 3-month moving average of the unemployment rate rises 0.5 percentage points over its minimum rate over the previous 12 months. It’s hard to envision a scenario where the unemployment rate will rise half a percentage point to more than 4% without recession, especially as the Atlanta Fed’s GDPNow model is already indicating that GDP is shrinking more than 1% during the present quarter.
Just as worrisome as the Fed driving the economy into recession are the gradually worsening financial conditions. The spread between the Moody’s Baa and Aaa-rated corporate bonds has been steadily widening since February. And, it’s trading near levels that in the past coincided with financial disruptions or widespread panic in markets.
For example, during the last 10 years, wide credit spreads correlated with the Covid-induced economic shutdown, the Fed panic of late 2018, and the European debt crises in 2012 and then 2015-2016.
What’s interesting today is that despite the steady widening in credit spreads since February, global financial markets have not been dealing with a major financial crisis. Instead, the pain is somewhat confined to weak equity and bond markets. But there seem to be a multitude of macroeconomic factors that could ignite some sort of crisis.
Interest rates have risen globally (and quickly so), which will likely choke growth. Input and living costs have risen as well, choking profit margins and consumer spending. And higher interest rates today will likely make it more difficult for the most leveraged or vulnerable consumers, corporations, and countries from easily rolling over their debts without significant haircuts to those debts and losses to their respective lenders.
While the losses in financial markets have been significant during the first half of 2022, the Federal Reserve is unlikely to back away from its tightening campaign anytime soon. As a result, we expect to see more economic and financial pain ahead. There’s most likely a Fed relief rally in the future. But we believe that something more serious will need to break in the global economy and financial markets for the Fed to change its present course.
We’ve been asked: what should the Fed do? In our view, the fact that precious metal prices, such as gold, are not sky-rocketing but are actually trading in the lower end of their range of the last two years suggests that there isn’t much monetary inflation in the system. Therefore, the higher prices that the economy is experiencing lately is being driven more by specific supply and demand dynamics -- which may be caused in part by global supply chain disruptions, historic fiscal spending, business closures of the last two years, and changes in consumer spending patterns due to the pandemic. In which case, the market for these goods and services are going through a “price discovery” that will eventually lead to more normal supply/demand balances and more stable prices. Given this classical economic point of view, the Fed should ensure that gold prices remain stable and long-term inflation expectations remain anchored, while at the same time not aggressively slow the economy and consequently create additional noise in the price discovery process. Doing so would arguably make supply/demand imbalances even more difficult to normalize and create additional economic pain to consumers and businesses.
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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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