FED, Recession & Reactions

FED – Policy Rates and Inflation

On it’s fight against the inflation, FED has been harshly criticised either for not acting at the right time or not at the right measure. Considering the “transitory” speech, underplaying the data and dismissing the concerns about inflation, this camp really had sound grounds. On the other hand, FED might have its own arguments based on stumbling economy, post-Covid recovery and tight job market in the past. All in all, this is not an article to take side or blame parties, rather to present the outlook after the recent meeting.

The Federal Open Market Committee (FOMC) increased the policy rate 75 basis points (bps) on its June meeting, and this was the largest increase since November 1994. Then, at yesterday’s meeting, FED increased rates another 75 bps not to fall behind the curve (or to step ahead of it). Although it was perfectly in line with the expectations, such high and consecutive hikes are rare in the history, and I am in the opinion that these rate increases and actions taken have restored the credibility. We have heard convincing explanations and it must also be noted that this hike was in an unanimous vote, which is also a good sign. Finally, lower and upper bands of the federal funds rate reached to 2.25% and 2.50%.

On the Graph 1, blue lines show the target range for the federal funds rate and pink columns depict the inflation rate. Based on June 2022 figures, annual inflation rate in the US is 9.06%.

FED might now prefer to be data dependent, but that doesn’t dismiss the forward guidance. Based on the latest FMOC Minutes, I have also added the FED dot plot. Graph 2 basically indicates us, how might the interest rates move. While yellow circles show the each FMOC Member’s projections, green line represent the median of dots. Therefore, following this median value, we can conclude that, year-end projection for the federal funds rate is increased to 3.40%. By the end of 2023 we will see more hikes on the road and 3.80% might be the peak. Although my guess is 4.00%. Then, market expects a normalisation and reaching to 2.50% level in the long run. 

You can find the recent FOMC statement via link.

RECESSION – Definition and Current Situation

When Federal Reserve Chair Jerome Powell made his announcement for landing from the cockpit, many people got a little bit confused. What would “soft landing” mean for the economy?

It means that “We will increase the interest rates in huge amounts to tame the inflation, which hit the forty-year high by the way, but we will not let the economy fall into recession.” And would be achievable through the storm of souring oil and gas prices, uncertainties all around the world and with a tightening financial conditions?

Answers to this question, let some to buckle their seatbelts and keep drinking as they trust the captain; and let some to jump from the plane with (or without) parachute as they had a bad taste of the past in their mouths. So what is recession then? Why does it scare some people even to jump from the plane without thinking?

If the stock market will crash and recovery is not in the horizon for a long time, then flight to safety might be a good choice. But let’s have a look at the definitions of recession first. There are two definitions and it’s here where the confusion begins.

Technical recession: According to academics and many professionals, generally accepted definition of recession is; “Two consecutive quarters of decline in a country’s Gross Domestic Product (GDP).” This looks pretty simple, measurable and comparable across the contries.

NBER definition: National Bureau of Economic Research dates U.S. business cycles and their understanding of recession is quite different: “A recession is the period between a peak of economic activity and its subsequent trough, or lowest point. Between trough and peak, the economy is in an expansion.” Then NBER explains this process in detail: “A recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months. In our interpretation of this definition, we treat the three criteria — depth, diffusion, and duration — as somewhat interchangeable.“

As it is seen, compared the technical definition, this is more opaque and not convenient to match with other countries. But sometimes they fit perfectly. If the economic activity declines more than six months, this makes two quarters data really negative. However two consecutive negative GDP data might not mean a wide spread and significant decline.

On Graph 3, you see the percent change in real GDP from the preceding quarter. In 2020, NBER declared a recession and two years later we are again at the same point with counter argument. Yes, indeed GDP had two consecutive negative values (-%1.6 and – 0.9% in 2022 q1 and q2), but the effect is not so drastic.

On Graph 4, we can follow which item contributed the most in percent change in real GDP. Net exports of goods and services, and services actually pretty solid and give tailwind to the GDP. However change in private inventories and fixed investments reflect the negative mood in the economy.

When it comes to job growth and consumer spending, who propose a non-recessionary state, the picture is also open to debate. On Graph 5, there is a continuous increase on total non-farm job openings. Covid-19 was an incredible hit and eventually pushed the economy into a short recession, but the trend is still solid. Only concern is that, it might have been peaked in March and direction might be South.

The second item is Personal Consumption Expenditure and on Graph 6 we can see that it is also very strong. The collapse in March 2020 imitates the job openings graph. However, it can be inferred that consumption expenditure is still sound and gives hope to soft landing supporters.

In Conclusion:

Real GDP has declined in two consecutive quarters, and with this data it can be called a technical recession. On the other hand, economy is still strong and some other measures do not show a gloomy picture. Therefore NBER might not call it a recession and this wouldn’t be contradictory. Besides, GDP data that shows a minus 0.9% decline in the US economy, will be revised two times. This is an advance estimate and open to change, which means that in the end it might even turn to positive. If it happens, then NBER might be right and technical recession would not count at the end of the day.

Market Reactions

Following the FMOC meeting stock markets were at risk-on mode. Both S&P 500 and Nasdaq 100 closed from session highs and recorded good increases. Market thinks that the peak in inflation might have been left behind and FED will succeed in “soft landing” scenario. At the other side of the story, bond market was turbulent and short-end yields plunged. As the FED made huge rate hikes, yields came down drastically. The question is, whether this is a return to bull market or a bounce from the over sold market. Everybody has its own answers, but let’s have an eye on the breakevens to get a glimpse.

On Graph 7, you can see three different lines for different maturities. 2-year (red), 5-year (blue) and 10-year (white) lines support the above argument. Inflation expectations are receding and the peak were around March in all three of them. Rates fluctuate around 3 percent level, commodity prices and Treasury yields also fell from their peaks.

We can follow the similar trend on Graph 8, which shows the US Treasury Inflation Indexed Securities. Considering the relevant, nominal Treasury maturity this graph shed light on the expectations on the market. In addition to above mentioned FED dot plot, Mr. Market expects 50 -25 rate hikes and a control on the inflation. However, it is apt to remind that FED left the door open for another big increase, incase data force it. Therefore, risk-on mode might bring good returns, but acting diligent in such a turbulent weather is wiser and safer. Although it is not in the graph, yield curve looks almost like this with different values from 2.3% to 3.0% for different maturities, but after 2Y to 10Y maturities yield curve is inverted.

Before I conclude, I’d like to touch upon one another related indicator. As we talked about breakevens and falling Treasury yields, one should also check the MOVE Index and Term Premium. On Graph 9, you can see MOVE Index with a blue line and the name comes from the Merrill Lynch Option Volatility Estimate. This Index helps us to find our path in the foggy fixed income market, as the volatility makes decision making very difficult. Future volatility is calculated by the implied yield via current prices of various maturities. Currently, the MOVE Index is at 128,55 and this is well above from the 80, which was the level at the beginning of the year. This means that although market is not so happy with the recent conditions, there is still room to be in the position.

In addition to that, you can also check the ACMTP 10 Index (white line) from the same graph. Term premium is an important and complex concept, and it is beyond this articles context. However, it can be seen as the extra return that investors demand in order to hold long-term instruments. As the duration increases, risk also increases. Therefore, investors seek a compensation. On graph, we see that after May, the values turn to negative and attempt to get in again positive territory in June. However that doesn’t pay off. Recent value is minus 0.653 and it suggests that macroeconomic environment is not so perfect. Although the medium of writing was Turkish, for further reading you can jump to my earlier article on Yield Curve and Term Premium.

Finally, all these are just the presentation of the outlook after the FED – FMOC meeting. If you believe in the positive scenario, it might be a good time to invest, as priced are decreased from the previous peaks. On the other hand, if you are in the opinion that recession will not be short and shallow, it might be good to take some profits, wait aside till the price retreat a little bit more and come back when the tide is over. It’s all up to you, and how you read the data.

I wish you all successful investments and trades.

Ergun UNUTMAZ, 29.07.2022