The Federal Reserve is likely to push the economy into a recession if it doesn’t lay off its rate hikes—that’s one interpretation of market movements following the Federal Open Market Committee policy decision Wednesday.
While stocks gyrated in the immediate aftermath of the Fed’s decision to raise interest rates by 50 basis points, the SPDR S&P 500 ETF Trust (SPY) ultimately ended the session with only a modest 0.6% decline.
On Thursday, the market’s reaction was more emphatic—a 2.4% decline for SPY and a 3.4% drop for the Invesco QQQ Trust (QQQ).
While the Fed’s half-a-percent rate hike was widely anticipated, it was the central bank’s forecast for future rate hikes that was more aggressive than investors had hoped.
In the latest Summary of Economic Projections released Wednesday, the Fed officials forecast that their benchmark rate would reach a peak of 5.1% and stay there throughout 2023.
That’s higher than the 4.9% peak that markets are still pricing in, based on federal funds futures. The 20 basis point gap between the Fed and the market isn’t all that significant, but where the Fed and markets stand far apart is what happens after the peak in rates is reached.
The Fed expects it will leave rates at 5.1% throughout 2023, while the market is expecting at least two rate cuts.
The Tale of Two Landings
There are a few ways to interpret what’s going on here. One interpretation is that the market believes inflation is on the downswing—a view corroborated by this week’s reading on consumer prices for November.
If that’s the case, the Fed has no reason to leave interest rates so high, and it will happily start cutting rates later in 2023 as it becomes increasingly clear inflation isn’t a problem anymore. This is the soft landing scenario.
The other interpretation is more ominous. In this scenario, not only won’t inflation be an issue in 2023, the Fed’s rate hikes will push the economy into a recession, forcing the central bank to reverse course sometime next year.
In either case, it’s clear the market believes inflation won’t be a problem next year. It’s harder to ascertain what the market thinks about economic growth by just looking at its projections for the fed funds rate.
The market’s prediction for lower rates could be the result of a soft landing or a recession.
But if you combine what fed funds futures are telling us with signals from other markets as well as the latest economic data, you start to see worrying signs.
The 10-year Treasury yield dipped to 3.43% on Thursday, close to its lowest levels in three months and nearly 80 basis points below its highs of the year after the government reported that U.S. retail sales fell by 0.6% in November--the largest decline in a year.
The yield on the 10-year is now a whopping 167 basis points below the Fed’s projected peak for its federal funds rate.
It’s hard to imagine the 10-year yield trading so far below the federal funds rate if bond traders didn’t think a recession was a distinct possibility.
Then there’s the stock market, which tanked 2% Thursday. The S&P 500 is still a good 8.5% above its October lows, so you can’t read too much into this one-day move—but the stock market’s post-Fed-meeting downward trajectory fits into this idea that the Fed could overdo the rate hikes and push the economy into a recession.
For the past six months or so, the stock market has swung up and down based on the likelihood of a soft landing versus a hard landing. The S&P 500 is down about 18.5% from its highs—a notable decline but nothing that necessarily screams “hard landing.”
Still, investors collectively edged closer to the hard landing camp Thursday.
When it comes to the bigger picture, investors are still split in terms of whether a recession can be avoided or not.