Multi-Asset: They've hit the panic button

On the Mark – Multi Asset Strategy - March 2022

Summary:

Puzzles in fixed income markets

Harbinger of recession

Brainard’s Speech

Since 1977 the Federal Reserve (the Fed) has been required to conduct the nation’s monetary policy to support the goals of maximum employment, stable prices, and moderate long-term interest rates. Often referred to as the “dual mandate”.

With monetary and fiscal support, the US economy has quickly recovered from the Covid shock of 2020 and as shown below in Figure 1, consensus US GDP growth expectations are 3.7% in 2022 and 2.5% in 2023.

Figure 1. US GDP consensus expectations

Equally, employment has made a strong recovery with unemployment falling from over 14% at its Covid highs in April 2020 to its current reading of 3.6%. This brings the unemployment rate within one tick of the pre-pandemic trough and close to a rate not seen since 1969 (Figure 2). Additionally, private payrolls are just 869,000 short of their previous peak which at the current pace of job growth should be recovered in Q2 2022. As a result, unless more people continue to join the labour force, the US will soon approach full employment.

Figure 2 – US unemployment close to levels not seen since 1969

So, this is all good news on the employment front but inconveniently inflation is now much higher than most expected; including central bankers. In many cases we are approaching frightening levels not seen in 40-50 years, as amply illustrated in Figure 3 below.

Figure 3. US Consumer price inflation

Source:  Bloomberg

Just to remind us all, in the second half of 2020 Fed Chair Powell announced a major policy shift to “average inflation targeting”. That means it will allow inflation to run “moderately” above the Fed’s 2% goal for “some time” following periods when it has run below that objective. As we have previously stated, to you and me that means that they will be “behind the curve” and they will make a policy error.

In a hawkish pivot in December 2021 Powell effectively jettisoned the Fed’s previous stance on soaring inflation and signalled his support for a faster reduction of the central bank’s massive bond-buying programme, giving policymakers leeway to raise interest rates more quickly than expected. After years and years of low inflation, the Fed had to re-establish their credibility in respect of fighting inflation. The global economy is already dealing with the after-effects of the gigantic shock from Covid but is now facing the consequences of a brutal war in Ukraine. The massive initial surge in goods buying during Covid already exacerbated supply chain constraints and then the war has led to a massive spike in most commodities, but especially the important energy complex. No doubt more is yet still to be discovered and there will be numerous unexpected effects. The Fed now face multiple problems which cannot all be resolved using traditional monetary policy.

Unsurprisingly at its March 2022 meeting, the Fed raised rates by 0.25% for the first time since 2018 and further signalled a much stronger bias on the part of the entire FOMC to raise rates aggressively this year to contain inflation. However, the Fed's forecasts suggest officials believe they can still bring inflation down without having to raise interest rates much higher than 3%.

Figure 4. Fed “Dot plot” – implied interest rate target

Source:  Bloomberg

Just after the Fed’s meeting and Chair Powell’s speech, Jim Reid of Deutsche Bank pointed out that the 5-year – 10-year US Treasury curve inverted, a harbinger of recessions which usually precedes the 2-year- 10-year US Treasury curve inversion (the standard most look at) by weeks. At the time the 5s10s had just inverted and in the updated chart below, we can see that it has now even more inverted.

Figure 5 – US Treasury curve 5’s 10’s

Source:  Bloomberg

On cue, a few weeks later the 2’s 10’s US Treasury curve indeed inverted, as suggested in Reid’s article.

Figure 6 US 2s10s curve

Source:  Bloomberg

Reid states plainly that all “hiking cycles that invert the curve lead to recessions within 1-3 years” and all but one of the recessions inside 37 months occurred when the 2s10s curve inverted before the hiking cycle ended.

More on this can be found here: https://www.zerohedge.com/markets/all-hiking-cycles-invert-curve-lead-recessions-within-1-3-years

In summary, we have reasonably robust growth, unemployment near record lows and a Fed playing catch up, as inflation rips higher. The Fed has only just begun its rate rising campaign with a 25bp increase and a dot plot indication to get to circa 3% by 2024.  However, the US yield curve is partially inverted and the all-important 2’s 10’s just inverted for a brief spell. i.e., the markets are signalling that the Fed’s rate increases will spark a recession.

Why should one worry about this?

Recession spells trouble for risk assets and generally leads to large corrections of greater than -20% for US equities. Whilst it is unlikely that this outcome would be realised in 2022 it certainly puts down a marker for a very difficult 2023.  

But something really puzzles us, the normally dovish Brainard (Fed Vice Chair in waiting), just said that the Fed “will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting.” She added that the Fed was also prepared to take “stronger action” when it came to tightening monetary policy and made it clear that “given the recovery has been stronger and faster,” the balance sheet will shrink much more this time than when the Fed attempted quantitative tightening in 2017 and 2018. This had the short-term effect of un inverting the 2’s10’s part of the curve.

But what was the aim?

Perhaps this was an attempt to restore the credibility of the Fed’s ability to fight inflation but the reactions in other markets do not back that up. See the Bloomberg Points of Return article by Auther’s on the 06/04/2022 and a recent Armstrong’s FT Unhedged for more on this.

Additionally, it is generally agreed that we have little idea how Quantitative Tightening will impact markets and any follow through into the real economy. Indeed, the Fed admitted “there is less uncertainty about the effects of changes in the federal funds rate on the economy than about the effects in the Federal Reserve’s balance sheet” Given that, why would the Fed now advocate a much more aggressive wind down, when markets are already signalling that there is an elevated chance of recession?

It doesn’t sit well with our team, and smacks of panic at the Fed – policy error looms ever larger in our minds. We are very mindful of Nomura’s Charlie McElligott’s point that the real contraction signal is not actually the curve inversion (albeit it is an essential part of the sequence) but instead the signal is when we get the steepening which tells you the market is “smelling the recession”.

We are watching the curves like hawks.

Just in case you are of a similar opinion please consider the following articles, including the view from our Fixed Income Team:

https://www.epicip.com/markets/EPICInsightsData/22

https://www.zerohedge.com/markets/world-war-global-recession-next-and-then-qe5

https://www.zerohedge.com/economics/road-next-recession

Mark Harris
Fund Manager, Multi Asset