Fed Rate Indicator Hints at Possible Cuts as Recession Fears Loom

A widening gap between the Fed funds rate and the 2-year Treasury yield raises concerns that a recession may be imminent.

Warning Signs: Barron’s has spotlighted the widening divide between the effective federal funds rate (EFFR) and the 2-year Treasury yield as a potential red flag. As of September 9, 2024, the EFFR sits at 5.33% while the 2-year yield has dipped to 3.68%, creating a 136-basis-point gap—the largest since January 2008. While this isn’t an automatic signal of a recession, it strongly hints that a shift in monetary policy, akin to the rapid response during the 2008-2009 financial crisis, could be on the way.

Recession Risks:?Historical data from the Federal Reserve Bank of St. Louis reveals that a recession typically follows within two to twelve months when the rate gap drops below -100 basis points. Although Barron clarifies that this isn’t a "balance sheet recession"—as public debt is still low and asset prices haven't crashed across the board—the risk is clear.

Mounting Pressure: While the broader economy may still hold steady, commercial real estate (CRE) already feels the weight of this monetary environment. Many CRE owners are struggling with substantial debt and falling property values while rising operating costs and tightening liquidity are fueling the fire.

Is It Enough?: Scott Rechler, CEO of RXR, has warned that even with potential rate cuts, the Fed may not lower rates enough to provide the lifeline CRE needs. Speaking with Bloomberg, Rechler noted that higher interest rates might be here to stay, signaling a prolonged adjustment in property valuations and financing structures.

What-If Scenarios:

1. What if the Fed Implements Aggressive Rate Cuts? If the Federal Reserve implements significant rate cuts to close the gap, it could have a twofold effect. On the one hand, such a move would likely provide immediate relief to debt-laden sectors like commercial real estate and businesses dependent on short-term borrowing. It would lower financing costs, potentially staving off defaults and bringing stability to the property market, which has been under immense strain. Moreover, consumers might feel a resurgence of confidence as borrowing becomes more affordable, leading to a temporary boost in spending and investment.

However, aggressive rate cuts could also reignite inflationary pressures, especially if the economy isn’t deep into recession. This could create a tug-of-war between managing inflation and supporting economic growth, potentially forcing the Fed into a difficult position where they might need to reverse cuts quickly, destabilizing markets even further.

2. What if the Fed Holds Steady or Delays Rate Cuts? On the flip side, if the Fed remains cautious and decides to hold rates steady for longer, the recession risk could deepen. Businesses already under strain from high borrowing costs might start laying off workers, contributing to rising unemployment. Consumers could pull back on spending, fearing that a downturn is inevitable. This "wait-and-see" approach may also exacerbate the issues in commercial real estate, as properties will have to continue contending with higher financing costs and lower valuations for a prolonged period.

A delayed response could result in a more severe and prolonged recession, echoing past economic downturns where central banks were slow to act. The risk here is that the damage to the economy could become more entrenched, requiring even more drastic measures, such as emergency rate cuts or additional stimulus packages from the government.

3. What if Inflation Reports Show Mixed Results? Another complicating factor is the possibility that upcoming inflation data might send mixed signals. If inflation remains stubbornly high in some sectors but moderates in others, the Fed could find itself in a bind. They may prioritize inflation control over supporting growth, leading to a scenario where rate cuts are minimal or non-existent. This would likely lead to stagflation—a period of high inflation combined with slow economic growth—further complicating monetary policy.

In this scenario, businesses and consumers would only face higher costs with the relief of increased demand, causing growth to stall even further.

The Takeaway: The growing gap between the Fed funds rate and the 2-year Treasury yield is signaling difficult times ahead, especially for property owners, and there needs to be more indication that the Fed will swoop in for a rescue. With Treasury yields continuing to drop ahead of critical inflation reports, all eyes are on the Fed’s next move as the possibility of significant rate cuts looms.

As recession signals intensify and the Fed faces tough decisions, do you think it's too late to avoid a downturn?