Greater clarity on Fed Policy will improve bond market outlook
Recent deceleration in U.S. inflation levels notably changed expectations for economic outcomes related to monetary policy. While inflation moderation supports markets, we do not believe that the full economic impact of the Fed’s tightening efforts is sufficiently priced in. Stagflation expectations are falling, with markets pricing in a shift toward the kind of moderation associated with a soft landing. Our market implied-probabilities framework suggests investors believe that the probability of a soft landing is close to 75%. Still, recession remains our base-case scenario.
It’s hard to envision an environment in which inflation falls materially without raising the unemployment rate. The Fed has made it clear that it won’t stop tightening until it’s confident inflation is under control, which is unlikely to occur until the labour market softens to a degree that reduces consumer spending and wage pressure. As a result, the risk of a recession remains exceedingly high, both in the U.S. and globally. It’s likely economies in Europe and the U.K. are already contracting and will probably feel more pain due to their lack of self-sufficiency in food and energy supply chains.
Trending Towards Recession
Looking at the data, we appear on our way to a recession, but whether it will be mild or deep depends on the Fed. We are progressing quickly through the business cycle, led by inversion in the yield curve. In the U.S., two-year rates inverted with 10-year rates at the end of March 2022, with three-month rates following suit in October. Higher rates typically tighten credit conditions, which has been evident in feedback from loan officers at big banks through the Fed’s SLO Survey.
Weaker corporate fundamentals come next, and downward revisions to corporate earnings continue to take place. These conditions lead to an economic recession. The Fed aims to raise rates enough to cool demand and slow inflation without triggering a deep recession, though only time will tell if the results are consistent with its goals. In the U.S., we’re expecting a slightly above-average recession with a peak to trough GDP decline of ~4%.
Nearing a Turning Point for the Fed
We expect a peak in the Fed’s short-term interest rate hikes in early 2023, possibly even January. After that, we believe the Fed will pause a few months and wait for data to show whether the aggressive tightening has worked. If we get supporting data confirming economic contraction with higher unemployment, lower inflation and core PCE trending closer to 3.5%, we think the Fed will pivot sharply with precautionary rate cuts in the second half of the year to save the economy from falling into a deep recession. This would be a boon for bond markets after a brutal year with negative returns.
Rates Revert to Lower Levels Over the Long Haul
While the current environment has been tough, we may be on the cusp of a new long-term bond bull market. The economic backdrop seems destined to return to a configuration more like pre-COVID conditions. Secular factors, such as an aging demographic and high debt burdens, are likely to drive a return to moderate growth and inflation, which should contribute to a lower interest-rate environment—albeit with some variation in the Eurozone market.
We may be seeing a mini-1980s reset in the level of interest rates. But when looking back from a future vantage point years down the road, it will likely be clear that current times included the highest levels of growth, inflation and interest rates for a very long time. So, wherever rates peak—and we think it’s highly likely that most of the increase in rates is behind us—it will be at a level of global interest rates that will likely prove to be the high-water mark for years, decades or maybe even generations to come. Given today’s higher yields and potential for future capital appreciation as rates decline, now may be an attractive entry point for long-term investors.
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