Ali Jaffari, Head of North American Capital Markets
It’s no surprise that US GDP growth is declining given the slowdown in consumer spending and domestic production recently, however markets seem fraught with headline risk with the term ‘technical recession’ floating around. Here are our views on what this could mean for markets and the risk factors to watch out for.
Through our weekly write-ups, we’ve long highlighted the looming risk of a recession given the central bank’s aggressive tightening cycle. Fed chair Powell himself has acknowledged that avoiding an economic contraction is becoming less likely. One of his preferred indicators, the spread between the 18-month and 3-month benchmark on the Treasury curve, has fallen by 95bps over the last month – the largest monthly decline on record.
Despite a technical recession now underway (defined by two consecutive quarters of GDP decline), the Fed remains at ease and is yet to flinch. In a move to restore its credibility, we’ve seen consistent messaging from the Fed in recent meetings, with the top focus being on leveraging its monetary policy tools to combat inflation. The Fed remains in the camp that a true economic recession is not yet present given that broader economic activity remains afloat, and that the labor market continues to strengthen.
As we enter into the next the economic cycle and weigh out the impacts of a ‘soft landing’ effect on the economy (as desired by the Fed) vs a full-fledged recessionary environment, here are a few points to consider that could steer us in either direction.
If we look back to the Volcker era (a period frequently referenced by Powell), inflation as measured by CPI was just shy of 15% in the early 80s. Volcker was successful in bringing the headline figure back down to sub 4%, however it took a considerable amount of tightening (the Fed funds rate was increased by almost 9% in a 2-year period). Granted, we live in a different economic environment now, however, ghosts from the past appear to have re-emerged and certain trends still hold true. The result of the excessive tightening back in the 80s led a to a deep recession. Hence, it begs the question whether the Fed will continue to battle higher inflation at all costs, and if so, what does this mean for the dollar?
It seems far-fetched to think that inflation will fall to the Fed’s target band (2%), given the recent data prints that continue to break multi-decade highs. If inflation continues to surprise to the upside and aggressive tightening measures ensue, dollar strength may further persist as the divergence in policy rates between the US and other nations grow.
We highlighted in an article published at the start of July, ‘The (Inflation) Shock Is Over, Back to Normal?’, that the price correction seen in some asset classes (especially commodities) may be an indicator that certain inflationary forces (the transitory portion) are subsiding. With over 50bps of rate cuts baked into 2023, it feels a little bizarre that the Fed would reverse course so quick.
What we do see from the Volcker era, however, is that inflationary forces were quick to subside when the right amount of pressure was applied through the policy rate. If that holds to be true, perhaps we see less a deep recessionary environment and more of a soft landing engineered by the Fed. This would put a halt to the dollar strength and initiate momentum for a weaker USD as hikes are priced out.
In the recent FOMC, Powell continued to emphasize the strength of the labor market and saw past any recessionary effects. If this continues to persist, I find it hard to see a scenario where the Fed actively cuts rates, rather than slowing down the pace of its tightening. We could live in a recessionary environment here, where the Fed gradually hikes and pauses throughout its cycle as it reflects on the data.
Inflation data would still drive the way here, and the lack of aggressiveness by the Fed would limit the likelihood / impact of an economic meltdown. The USD is still likely to weaken in this scenario as the hiking cycle slowly tapers off.
Whether we fall into a deep recession or not, its clear the market remains fraught with headline risk and volatility continues to persist impacting hedging costs, return profiles and asset valuations. The next series of data points around inflation and employment will be critical in determining the Fed’s narrative, which will affect the subsequent economic cycle.
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