Powell vs Markets

In 2019, the Fed pivoted hard and the economy managed a proverbial soft landing. The 2018 hiking cycle which Powell abruptly reversed with his early 2019 pivot slowed the economy down, but not nearly enough to result in a hard landing.

The first innings of a recession always look like a soft landing, as growth and inflation come down but not to alarming levels yet – exactly like today.?

As markets myopically embrace this soft landing narrative, Powell’s lack of pushback against easier financial conditions adds fuel to the fire.

Taking a deeper look at what Powell actually said, it becomes increasingly clear markets don’t believe him.?

What’s the bond market trying to tell us here?

Markets are currently pricing a US soft landing as the dominant probabilistic regime (~65% probability), and in recent weeks the left recessionary tail has been aggressively priced out (now ~15%) while the chance of a strong growth regime ahead has been bumped up to ~20%.

Even after the apparently very hot labor market data and ISM services, the bond market keeps screaming immaculate disinflation/soft landing as the main regime ahead.

? Fed ‘’soft landing’’ cuts are priced in: as inflation slows down but without a recession, the Fed can gently cut rates to neutral levels (2.50-2.75%) without resorting to recessionary cuts or being forced to keep rates higher for longer.

? Inflation is priced to drop to 2.5% by year-end, and stay close to 2% in the long run;

Powell reiterated that while the “disinflationary process” had begun, continued interest-rate increases will be appropriate. The central bank will remain focused on the monthly data and make decisions one meeting at a time, he emphasized.

Powell used last month’s robust hiring to highlight exactly why the central bank can’t ease up in its inflation battle just yet. He also pointed to the bright side.

The jobs report “shows you why we think that this will be a process that takes a significant period of time,” Powell said. “The labor market is extraordinarily strong. And, by the way, it’s a good thing that inflation has started to come down, not at the cost of a strong labor market.”

The Fed’s plan is still to raise rates further, then wait and see what happens, Powell said.

“Our message was, ‘This process is likely to take quite a bit of time, it’s not going to be smooth, it’s probably going to be bumpy,” Powell said, referring to getting inflation back to the Fed’s 2% target. “So we think that we’re going to need to do further rate increases, as we said, and we think that we’ll need to hold policy at a restrictive level for a period of time.”

A tight U.S. labor market gives the Fed more cover to raise interest rates, and hold them higher for longer, as officials wait for the cumulative tightening from the past year to bring down inflation.

The bottom line: inflation isn’t vanquished yet, the Fed isn’t done tightening yet, and officials will be closely watching the data to determine the timing of the central bank’s policy pivot.

Recession Alarm!

The inverted yield curve is nothing new!

The spread between the yields on the two- and 10-year Treasury notes, however, is approaching a level not seen since 1981, according to Dow Jones Market Data.

Under normal circumstances, bonds with longer-dated maturities have higher yields than those set to expire sooner. But not lately.

On Oct. 2, 1981, the inverted spread between those two securities was at 96.8 basis points. Although the yield curve hasn't reached that gap, it's not all that far off.