The market is betting the Fed will have to cur rates by September-December 2023.
- We don’t (yet) know if the market is pricing in a fast drop in other economic sectors. Many commentators (and the Fed’s own projections) expect a big drop-off, but the market’s mind is inscrutable.
- We know the probability of such a rapid downturn shrinks with every “not-so-bad” month of data we get. If things don’t start to drop fast soon…
So what if we keep getting ho-hum data and the market keeps pricing in Fed cuts?
- The good news is the market is likely pricing in “no major downturn ahead.” The Fed cuts to head off a banking crisis, not a recession.
- The bad news is we’ll need to adopt a more nuanced perspective on the economy.
One way or the other, the objective facts of the last 12-18 months have not supported a widespread belief that the Fed’s rate policies are “the” one-shot driver of the economy.
It is possible we see the scenario reflected in the Fed’s forecasts. A dramatic, immediate decline in not-so-rate-sensitive sectors. The whole economy slows to near-zero growth . Unemployment goes up. Rapidly over the next 6-9 months.
In that case, the Fed can declare victory and cut rates. Everyone will forget how little impact the rate increases had for how long. The Fed’s economic forecast lines up neatly with the market’s rate-cut forecast. Faith in the Fed will stay as fervent as ever.
But that broader slowdown must come quickly if it is to come at all…
Maybe we don’t see a tire-screeching economic halt? A lot of indicators don’t point that way. The Atlanta Fed’s GDPNow forecast is at 3.2% for 1Q23. Other indicators (the HYG index, for example), aren’t showing elevated risk.
Maybe we just see more of the same gradual fade of activity and inflation? Caused mostly by wages not keeping up with higher prices and other supply/demand factors. Along with the (so far surprisingly contained) damage the Fed has done to rate-sensitive sectors like Banks and Real Estate.
- Tidy Story: The steely eyed, technocratic Fed will raise rates and cause “a recession.” They will press until unemployment goes up…
- Messy Reality: If Fed keeps rates high enough for long enough, it will mechanically force a banking crisis in concert with a Real Estate Crisis. A Banking and Commercial Real Estate crisis would definitely cause a major recession.
The Fed doesn’t want to be directly responsible for sparking that crisis. That hoped-for unemployment would bloom over the corpses of the Regional Banks and a lot of (mostly private) private Real Estate fortunes. Piled up at the Fed’s door
In that case, the Fed probably declares victory and cuts rates anyway to head off a banking/CRE crisis. The “gradual fade” scenario above could be the actual forecast embedded in market expectations for rate cuts by the end of the year (80%-90% chance in November-December 2023). The rate cuts coming mostly heading off a banking/CRE bust, not a plain-vanilla recession.
The good news is its rate cuts would immediately affect rate-sensitive sectors. So the Fed has the power to stop a Banks and Real Estate death spiral (because “rate-sensitive”). The market knows that. It expects the Fed to act.
The Fed’s calculus is tough. Their biggest achievement so far is a wholly avoidable Bank run. Yet credibility is a key asset. There is nothing more damaging than following through on a long-repeated “terrible threat” only to discover the consequences/costs aren’t nearly as big as imagined.
- How long can the banks hold out? How many Real Estate investors can avoid ruinous re-financing?
- How to balance that against how little impact to date the Fed’s rate increases have had elsewhere…? Other, less rate sensitive, sectors keep delivering month after month of “not obviously succumbing to interest rate pressure...”
- How to save face? Powell & Co. also set out 12-18 months with great faith. The economy was certain to fold after they put a few rate cuts on the table. They were forced to double down. Then double down again.
Never forget that Powell isn’t an economist. He’s a Wall Street capital markets guy. He had great faith in his institutional powers. Along with most of his peers. Because “everyone” knew the Fed was the one-shot factor in the equation. Today, Powell is looking perplexed, uncomfortable, and a wee bit nervous. Faith hasn’t been enough to carry the day.