Markets Chart of the week: Fed hiking cycles don’t always end in recessions

Federal Reserve policymakers are signaling their willingness to hike interest rates more aggressively to bring down inflation; they remain open to a 50bps increase in May. On Wednesday, San Francisco Fed President Mary Daly said, "I have everything on the table right now. If we need to do 50bps, 50bps is what we'll do”. She added that “with the labor market so strong, inflation, inflation, inflation is top of everyone's mind." Separately, Cleveland Fed President Loretta Mester’s comments also indicate support for some front-loading of policy rate hikes. When asked about the path of rate increases, Mester said, "That better positions us if we do it earlier rather than later for what happens in the second half of the year." And earlier this week, Federal Reserve Chair Jerome Powell said the US central bank would not shy away from raising rates to restrictive levels if needed to control inflation. He added that there was nothing to stop the Fed from implementing a 50bps hike.

With inflation and wage growth surprising to the upside, the Fed seems to have run out of patience and is currently in inflation-fighting mode. Markets have responded accordingly—the federal funds futures market is now pricing in more than 200bps of hikes this year, including the recent 25bps rise. Fixed income markets are expressing concerns about the impact of aggressive tightening on GDP growth—the 2-year/10-year US Treasury spread is around 20bps and the 5-year/10-year US spread is now below zero.

While uncertainties about the Russia-Ukraine war present downside risks to US GDP growth, in our central case we think the US economy will be able to withstand what is likely to be the swiftest pace of policy tightening since 1994 as;

1. A flattening of yield curves is not a sign that markets expect an imminent recession. An inversion of the 2-year/10-year curve has preceded every recession in the last 70 years. While the curve has flattened to around 20bps now, from around 90bps earlier in the year, it is still positive. Even when recession did follow a curve inversion in the past, there was a long and variable lag. Recessions started, on average, 21 months after an inversion, with a range of 9–34 months.

2. The Fed has a record of tightening rates without causing recessions. As observed by Powell, the Fed pulled off rate rising cycles without causing recessions in 1965, 1984, and 1994. Other recessions, including the pandemic recession of 2020, were not the result of monetary tightening.

3. Rising wage income and strong household balance sheets will likely support consumer spending. The US personal savings rate, at 6.4%, is now in line with pre-pandemic norms, but strong wage growth (the Atlanta Fed’s wage tracker hit an all-time high at 5.8% y/y) and a surge in household wealth on the back of equity markets and home prices will likely support consumer spending. We believe there is still pent-up demand for the services that were most impacted by the pandemic, as well as for goods that have been in short supply, especially cars. We expect economic expansion to continue because GDP will be determined by supply-side limits rather than demand. Bottlenecks have started to ease, and rates are unlikely to rise so high that they dissuade businesses from investing to increase capacity. In our central case, we expect US GDP growth to remain above trend, at 3.6%, this year.

4. The Fed still has the choice to slow the pace of rate hikes to meet its dual mandates. Powell has said that the Fed is willing to push rates into restrictive territory, but this does not mean it would be unresponsive to slower GDP growth due to policy tightening or other headwinds, including the Ukraine war.

So, while there is widespread criticism and increasing concern, it’s too early to take the view that the Fed won’t be able to negotiate the fine line of reducing inflation without derailing GDP growth. From an investment perspective, we recommend investors brace for higher rates by considering exposure to US senior loans, which offer an attractive yield and a floating rate structure. Among equities, we like sectors that typically outperform in this environment, such as value and financials.