Hikes, Inversion, Recession?

We have lift-off

On the 16th of March, the FOMC raised the policy rate (federal funds rate) by a quarter of a percentage point (25bps), initiating lift-off after two years at the zero lower bound, in what is certain to be the first of many. More importantly, they ratified market’s expectations of a hike in every meeting in 2022 through their Statement of Economic Projections – their principal forward guidance tool.

The Fed also said that they are on track to announce the beginning of Quantitative Tightening (QT) in the coming meeting. While the pace at which the balance sheet shrinks is not known yet, Chair Powell has indicated that the process may take around three years to bring the balance sheet down to a size that would be consistent with a neutral balance sheet, which indicates a cap around 80 billion per month. Though the impact of changes in Fed’s asset holdings on financial conditions is somewhat uncertain, the amount of QT done this year could be considered equivalent to a rate hike.?

The immediate reaction in the market wasn’t exactly bearish! This is partly because some in the market may have gone into the meeting expecting a 50bps hike and also perhaps due to Chair Powell stating that the shrinking of the balance sheet may be equivalent of an additional hike. However, as the FOMC members came forward to speak after the long blackout period, each of them was more hawkish than the other.

Christopher Waller said that had it not been for uncertainty created by the Ukraine-Russia conflict, he would have voted for a 50bps hike in March itself. Neel Kashkari, largely considered to be the most dovish of the FOMC members, said he had penciled in seven hikes for 2022. To top it all, James Bullard, who had already dissented in the meeting in favor of a 50bps hike, said he would favor pushing the federal funds rate north of 3% by the end of this year.?

What caused this dramatic shift in the FOMC’s preferred policy path? Inflation! We witnessed a spike in inflation in the later part of last year that was driven by idiosyncratic shocks in few segments, particularly within goods (second hand cars being a prime example). But as we moved into 2022, inflation began to broaden into the service sectors of the economy where price pressures began to pick up more notably and began to lead the inflation data higher. And while the Fed may still have reason to believe that a significant build-up in inventory and depletion of household savings would eventually push inflation lower, it had been too high, for too long for them to play the waiting game. Making matters worse is the Russia-Ukraine conflict, which is pushing food and energy prices higher across the world. Normally, the Fed would look through this kind of inflation, but given how broad-based inflation is, they are forced to act to prevent inflation expectations from de-anchoring any further.

The pivot drew a very strong reaction from the market as we went from pricing three or four hikes in 2022 to a total of ten hikes, with an upward revision to the policy forecast from nearly every private forecaster as more and more people come onboard with the idea of an aggressive and frontloaded hike cycle, as policymakers hurry towards a more neutral setting. Of course, the US rates market wasn’t the only one to witness such an aggressive sell-off – Canadian, German and even Japanese rates sold off to levels not seen in several years.?

Yield Curve Inversion

5s30s, or the difference in yield on the 30-year treasuries and the 5-year treasuries, inverted today, for the first time since 2006. 2s10s may invert in the coming weeks!?

To the uninitiated, when yield on shorter term bonds, such as the 5-year treasuries, exceed that on longer term treasuries, such as the 30-year, the curve is said to be inverted. This is because investors are generally expected to demand higher yields for an investment of a longer duration. Historically, when we've seen that spread inverting, the market has taken it to be a signal that a recession might be coming. But does that need to be true this time? Though saying “this time it’s different” has seldom proved to be a good idea, there are a few things that we should note before jumping to a conclusion.?

First, indicators like the pace of job creation and business sentiment are holding up, which indicates the economy has considerable momentum going into this hike cycle. And even though the effects of fiscal stimulus will fade in the coming months, labor income is rising strongly and should lend support to consumer spending.

Second, the 3m10s spread is still positive and has more strongly correlated with recessions. Of course, one could argue that the reason 3m10s is steep and 2s10s (or 5s30s) is flat because the Fed hasn’t actually tightened policy yet, and it’s just the market anticipating the tightening due to the hawkish guidance. Accordingly, it would follow that even if yield curve inversions preceded recessions, one is not around the corner just yet.

Third, yield curve inversions don't cause recessions! The inversion is taken as an indication that the market expects the Fed to ease policy in the future, either in an effort to avoid a recession after having tightened policy too aggressively or, to fight an actual recession. While that characterization is not incorrect, there are other reasons why the yield curve could invert. For instance, in 2006, the yield curve inverted because of what was later described as the ‘global savings glut’ by Ben Bernanke, wherein the foreign investors where investing in longer term treasuries, pushing their yields lower relative to shorter term treasuries.?

Today, it’s the Fed that holds a large share of the market. More importantly, the biggest reason behind the flattening in the yield curve is the impact rate hikes is expected to have on inflation. This is made evident from the sharply downward sloping inflation breakevens curve, a commonly used proxy for market’s expectations of where inflation will be in the future.

Finally, while there is some credence to the fact that an inverted curve would reduce the growth in bank’s loan books, there is little evidence to support the claim that credit creation would cease entirely.?

To conclude, the Fed’s hawkish stance has led to the market pricing an aggressive and frontloaded hike cycle, which is expected to reduce inflation in the coming years. Accordingly, the yield curve has inverted since it’s difficult to achieve soft landing after a period of high inflation, but this doesn’t imply that a recession is necessarily imminent.

Bonus questions:

How does the Ukraine/Russia conflict effect the economy and hence policy? Aside from the uncertainty created by the conflict, the first impact is seen in inflation via food and energy prices. While the rally in oil is not entirely negative for countries like the US, which also produce a lot of oil, it does slow activity and disproportionately hit lower income households, which spend a bigger chunk of their income on food and fuel. Therefore, the impact might be a wash in the US, relative to say Europe, where it increases the risks of a recession more materially. Thus, the Fed is likely to continue raising rates despite the conflict.

How long does it take for those hikes to flow through into the economy to bring inflation down??

While it’s true that monetary policy works with a lag, it’s also true that the transmission of tighter policy via tighter financial conditions doesn’t await actual rate hikes. Indeed, given the sharp shift in forward guidance has been priced into forward rates, markets are already doing the Fed’s work for them. Therefore, we may start to see that tighter financial conditions (with some help from base effects and an eventual easing in supply chains) begins to reduce some of the steam in the economy over the next twelve months.?