Walking a Tightrope

The Federal Reserve believes that it has a job to do… to ensure full employment and price stability. With the consumer price index running at 7.9% year-on-year and likely to move higher over the next few months, the Fed is clearly feeling the pressure to act. Chair Powell strongly expressed this view at the National Association of Business Economics conference, saying that, “We will take the necessary steps to ensure a return to price stability. In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than (a quarter-point) at a meeting or meetings, we will do so.” When asked what would keep the Fed from raising interest rates by 50-basis points, he responded, “Nothing.” Unsurprisingly, the market is now starting to expect a 50-basis point rate hike at both the May and June meetings.

U.S. Treasury yields responded sharply to these comments with the 2-year U.S. Treasury yield climbing from 1.93% to 2.27% while the 10-year U.S. Treasury yield jumped from 2.15% to 2.47% by weekend. The spread between the two tenors (often referred to as the 2s10s yield curve) remained about the same (about 20-basis points from inversion). While an inversion of the 2s10s yield curve is often thought to be a precursor for a U.S. recession, Fed Chair Powell stated that he prefers the short-term Treasury curve. In his view, the short end of the curve is more accurate because it reflects when the market thinks the Fed is going to cut rates in response to weakening growth. There is some truth to that with the yield curve often steepening right before a recession, but we wouldn’t completely ignore the traditional 2s10s yield curve. While neither curve is currently signaling an imminent recession, the 2s10s curve is just 3 basis points from inversion at the time of this writing (see figure 1).

This chart shows the Fed’s Preferred Yield Curve (Short-Term Treasury Curve) vs. 2s10s Yield Curve from 1997 to 2022 year-to-date. U.S. Treasury yields have risen sharply as the bond market digests a more aggressive Fed.

Of course, the Fed is not trying to tilt the economy into recession. According to Powell, his goal is that “The economy achieves a soft landing, with inflation coming down, and unemployment holding steady.” But what are the odds the Fed accomplishes this? It is not zero as the Fed has done it before…in 1965-1966, 1983-1984, and in 1993-1995 (see figure 2). During those periods, the Fed tightened monetary policy with no contraction in real economic growth.

This line chart shows Effective Fed Funds Rate (%, End of Period) vs. Periods of U.S. Recession from 1955 to 2022 year-to-date.

To achieve its goal, the Fed may try to dampen demand in order to lower inflation. However, there are just a few examples of the Fed achieving a decline in core inflation without a subsequent recession. As figure 3 shows, during the past 11 Fed tightening cycles (as defined by Professor Alan Blinder of Princeton University), the unemployment rate continued to decline in each tightening cycle while core inflation continued to rise in 9 out of the last 11 tightening cycles. In previous periods of high inflation (1977-1980), the Fed raised rates by 1300 basis points, but core inflation did not come down until the economy tipped into a recession in early 1980 (inflation started to finally fall in January 1981). We think there are three key takeaways from figure 3: 1) the Fed is currently nowhere near telegraphing something like the 1000 basis-points of tightening that generated the hard landings in the late 1970s and early 1980s, 2) there are only a couple of examples of core inflation falling during a Fed tightening cycle, and 3) in 8 of the 11 past Fed tightening cycles the S&P 500 continued to rise. History suggests that absent a policy-induced recession, the Fed’s best hope is still a gradual normalization of global supply chains (something it has little control over). Such a scenario, would be consistent with the “robust” scenario that we have highlighted in our CIO Strategy Bulletin | Three Scenarios for the Economy and Markets.

Are There Currently Any Signs of a U.S. Recession Forming?

We think it is too early to make a U.S. recession call with our U.S. recession dashboard showing just three of eight metrics as flashing potential recession signals. Two of those metrics we feel reasonably confident in (a potential peak in the percentage of small businesses saying that now is a good time to expand and a potential peak in consumer confidence – both occurring in June 2021). The other metric is highly debatable with initial jobless claims hitting just 187,000 claims on March 19, 2022 – its lowest level since 1969. We think there is a chance that reading marks the trough, but we have no way of confirming that until we see more data. Based on these tentative signals a recession could be possible between March 2023 and March 2024 (see figure 4), but it seems way too early to make that call.

What Happens to U.S. Stocks in These Types of Scenarios?

Our base remains that the U.S. will avoid a recession, but we cannot completely rule out a “hard landing.” If that were the case, then historical returns suggest a peak in the S&P 500 about three months prior to the onset of recession with about a 30% drawdown in the S&P 500 during recessionary periods (see figure 5). Once a market bottom is reached, the S&P 500 often recovers quite quickly with the bulk of the recovery occurring in the first 12 months after the market bottoms. Therefore, we encourage investors to focus on “time in the market over timing the market” with the best gains often occurring within just weeks of the worst declines. During Fed tightening cycles when the Fed does achieve either a “soft-landing” or “softish-landing”, S&P 500 has returned about 7.4%. With such a wide range of outcomes, we continue to believe that a well-diversified portfolio and a defensive strategic asset allocation remains the best approach. We continue to favor pharmaceuticals, consumer staples, dividend growers, and natural resources stocks.

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