Markets now see a a 97.6% chance of a Fed rate cut by September 2023. Market consensus is “the Fed will have to cut rates because we will have a recession.” But what if we get a rate cut without a (major) recession? What if the Fed starts cutting rates while many sectors of the economy are doing OK?
The Fed itself is predicting only 0.4% GDP growth in 2023. The consensus view is below (per DataTrek)
Takeaway: Markets walked away from today’s FOMC announcement and Chair press conference even more convinced that the Fed will have to cut rates before the end of the year. The yield on 1- and 2-year Treasuries, which fell today to 4.51 and 3.96 percent, confirms that sentiment. That goes counter to the FOMC’s latest Summary of Economic Projections, as we will shortly discuss.
The important question is “what does the market think it sees”? The short answer is the growing risk of a US recession. During his post-meeting press conference, Chair Powell was very clear in his message that the Fed will not try to predict what effect a slowdown in bank lending may have on the American economy. Rather, it will wait and see what the incoming economic data has to say about both economic growth in inflation. The market seems rightly concerned about that idea. After all, by the time growth is clearly slowing and inflation is waning, it may well be too late to adjust monetary policy enough to avoid a significant economic slowdown. (DataTrek Research 23March23)
Either we are going to have a mega-fast deceleration over the next 3 Q’s or…. we won’t. The problem? The real economy doesn’t look to be cooperating.
- A 3.6% YoY growth forecast from the Atlanta Fed’s GDPNow estimate for the March quarter. This is usually directionally correct by this far into the quarter. https://www.atlantafed.org/cqer/research/gdpnow
- Unemployment is at 3.6% (the Fed’s expectations are 4.5% by year end but “everyone” knows that is a low-ball vs their real expected number).
- The labor market is showing no signs of cracking. Jobless claims went down this week. Vacancies remain high. Wage growth is solid.
Again, we do likely get a slowdown. Economic data points to deceleration. But there aren’t a lot of obvious signs of a screeching, shuddering, smoking-tires, next-3-6-months hard stop. Which is kind’ve what you’d need to see for the the Fed to start cutting rates big-time (97% chance) by September 2023.
Maybe the market is wrong about the rate cuts? Those expectations have bounced around a lot.
Or maybe the market is right about the rate cuts, but NOT because of a general recession? Maybe (ahem) incipient signs of crisis in sectors near and dear to the Fed’s institutional heart?**
Certain sectors – Banking and Commercial Real Estate – are definitely sliding into crisis. How fast and how deep and how bad? It depends partly on how you weight various scenarios. It depends mostly on the future trajectory of Fed rate decisions.
The Fed and the Treasury are ALREADY (quietly, but obviously) panicking. How else would you describe the last 2 weeks? What are they worried about? Bank failures. Driven by high rates (directly hurting bank profits) and by Commercial Real Estate (indirectly threatening bank loan books – especially smaller regional banks).
How does the Fed prevent those nightmare scenarios? They cut rates.
Even if the economy is NOT in a tailspin recession. Even if most of the economy is chugging along. Because the banking sector and Commercial Real estate are systemically important. They are also institutionally important to the Fed. And those sectors are pretty clearly already in a recession.
Seen in this light, the Fed is praying the headlines go its way on inflation and the economy. Declining headline CPI and some economic softening to provide a fig leaf of cover for a move the Fed is going to have to make anyway.
** Yes, a major Banking and Real Estate crisis would almost certainly cause a general recession. What I am saying is the Fed will act to save its children before we get to that major crisis and subsequent recession. We likely don’t get a real crisis if rates only stay high until September-December (per the market’s prediction). The crisis risk goes up as/if rates stay high into 2024. The problem with the Fed’s Higher for Longer promises was always the “for Longer” part.
More Context on the Slow-Rolling Crisis: From the Financial Times (subscription required).
But even if SVB-style dramas can be avoided, the pattern is creating “a long tail of zombie banks”, as the hedge fund Bridgewater says. “Policymakers can stop a bank run but unless the Fed cuts rates they can’t stop the repricing in banks funding costs.” That feeds into a third issue: a credit crunch. As funding costs rise, banks will cut loans.
In some senses this is what Fed officials want, since slower credit creation will curb inflation. But the rub is that it is extremely hard to predict the impact of a credit squeeze since it can create a self-reinforcing downward spiral of recession and defaults. So while the crisis in American banks was initially sparked by interest rate (and liquidity) risks, it could now slowly morph into a problem of credit risk too.
The $5.6tn commercial real estate lending market illustrates the problem. At present 70 per cent of these loans comes from small and medium-sized groups. “Small banks’ absolute dollar exposure to CRE lending has grown at an accelerating rate over the past ten years,” notes Morgan Stanley;
Even before the interest rate cycle turned, CRE values were starting to come under pressure because the rise of internet shopping and homeworking hurt retail and office space. But with rates rising, “all of a sudden those assets become very hard to roll over” as Rick Rieder of BlackRock says. Since $2.5tn of loans are due to be refinanced in the next five years, this will eventually create pain for borrowers — and banks.