The US economy suffered two consecutive quarters of negative GDP growth. PMIs too are declining. Hence, it isn’t surprising to see some recessionary indicators worsening and some anticipate a Fed pivot. What is a Fed pivot?
A big part of this summer’s rally was based on the growing expectation that the Federal Reserve was going to « pivot », that is, to stop raising interest rates further and possibly reconsider its tightening policy.
For much of the past three decades, slowing economic growth and a softer housing market usually led to a more cautious Fed, as the job market came under pressure. This time around, a combination of factors, such as declining commodity prices, and softer housing prices, together with the July FOMC meeting minutes which were less hawkish than anticipated led investors to hope for a similar outcome.
What are the chances for a Fed pivot?
Fed Chair Jerome Powell put an end to any hopes that the central bank would step back from its policy tightening anytime soon during the Jackson Hole meeting, as he reaffirmed his « unconditional » commitment to tackling high inflation.
Today’s environment differs considerably from what we were used to seeing in the recent past. Headline CPI running at 8.5% year-over-year, consumer spending remaining resilient, and especially the unemployment rate near multi-decade lows, give the Fed little reason to prematurely announce the end of the battle against inflation, even if some indicators suggest we are past peak inflation.
Fed pivot sceptics
Some observers believe the central bank is determined not to repeat its mistake from the 1970’s — in which the Fed made errors by easing policy prematurely to shore up growth but before inflation had moderated sufficiently.
This has led traders to shift their bets. Fed funds futures are now pricing in 100 basis points of further tightening across the next two meetings (September and November) with a further 25 bps hike fully priced in for early 2023. Looking further out, a 25bps rate cut is expected only near year-end in 2023.
Fed pivot could be close
However, there are some that argue the Fed does not need a return to 2% inflation to back off. What the Fed wants to see is prices forming a downward trend and inflation expectations remaining stable. To many, such an outcome is a plausible scenario a few months down the road.
For instance, the apparent rollover in oil prices is set to help ease some inflationary pressures, in particular as Brent crude typically has a strong correlation with headline CPI. Moreover, the broader pullback in commodity prices and supply chain inflationary pressures too could be interpreted as an indicator of softening demand, bringing relief to inflation pressures.
It is important to highlight that predicting accurately what will happen in the future is a complicated task. For instance, in 2015-2016, the Fed hiked only once against four expected hikes, effectively a net « loosening » of 75 bps relative to market pricing and expectations.
Would the stock market crash?
The possibility of recession has made it difficult for investors to be optimistic about the markets’ path in the coming months. Nevertheless, most of the bad news is mostly already baked in for stocks. And while Powell’s Jackson Hole speech caught some market participants by surprise, the bond market’s reaction was less meaningful; Treasuries slid but recovered in the following sessions.
Despite the current challenges, the majority of corporate earnings continue to surprise to the upside, and management guidance remains conservative, giving stock markets room to advance. In the US, even if volatility persists, the growth is still holding up, and earnings have remained surprisingly resilient for companies with pricing power. In Europe, the situation is more complex. With high and still-rising inflation mainly due to energy prices, which central banks have little control over, risks of a hard landing (recession) are high.
Conclusion
Investors are preparing for a longer period of high-interest rates after the US central bank Chair vowed to ensure elevated prices do not become entrenched. With the S&P500 currently down 17% for the year, stocks appear to have already priced in a mild recession—but not a deep one. The great unknown is how much the economy will actually slow in the near term and at what point the Fed acknowledges that. For the market, we believe that stocks could move higher going into the next year, though not without corrections.
