(The author is the Finance and Markets Editor at Reuters News. All views expressed herein are his own.)
By Mike Dolan
LONDON, March 23 (Reuters) – Tighten hard and fast now and you might avoid triggering a recession – it seems the Federal Reserve is tempted by its own playbook from almost 30 years ago.
In just 12 months since February 1994, the Fed doubled its main interest rate to 6% in seven rapid hikes, including two moves of 50 basis points and a buoyant 75 basis point hike as an encore.
Although it rocked the bond market – and some argue that it sowed the seeds for a series of emerging-market crises later in the decade – the Fed’s brief, sharp shock prevented an inversion of the 2- to 10-year Treasury yield curve, which many did the fall is the most reliable harbinger of an imminent recession.
True to the predictive power of the yield curve, a US recession was averted and the Fed managed a rare “soft landing” for the economy.
Given the distortions of a global pandemic and the energy price shock from the war in Ukraine, history may not be a good guide to anything right now. A lot has changed in the economy, bond markets and the banking system over the past three decades.
But it could still be useful for figuring out the Fed’s reaction function.
“Eat your heart out, 1994,” calculated the strategists at Morgan Stanley over the weekend.
The US Federal Reserve began its latest tightening cycle last week with a quarter-point hike in interest rates from near-zero pandemic adjustments. But with 40-year high annual inflation rates approaching 8%, policymakers’ projected rates may need to move well into the so-called “restrictive” zone over the next two years, above what they see as a “neutral” 2.4% .
Markets once again struggled to reprice the latest radical turn, and then on Monday Fed Chair Jerome Powell underscored this newfound “whatever it takes” approach to taming inflation by insisting the Fed should delay rate hikes 50 basis points if deemed necessary.
The story goes on
So much so, that futures markets are now seeing the Fed add another 200 basis points of tightening in its six remaining policy meetings of the year, setting a “terminal” or maximum rate that is both higher and earlier than previously thought — almost 3% by June next year compared to a combination of 2.5% by September 2023 last week.
Fed watchers have also rushed to recalibrate the magnitude of projected Fed hikes. Goldman Sachs economists now expect two hikes of 50 basis points each at their May and June meetings.
So far, so 1994. But what about the yield curve?
Having depressed a whopping 140 basis points over the past year – and even as other parts of the curve turned negative – the central gap between 2-year and 10-year Treasury yields remains only positive – even if it’s now less than 20 basis points a fatal reversal.
For the record, this gap reached just 7bp in December 1994 – just after the mega 75bp Fed thunderclap – but it never went negative.
Rough comparisons would suggest that even if the alarm bells in world markets should go off, we may be in for a long, nervous wait this time.
NARROW ‘SOFT LANDING’ STRIPE
Deutsche Bank and others recently highlighted how narrow the “soft landing strip” ahead of the Fed is, showing how delicate the balancing act will be without landing a collapse.
Both the Fed and markets now agree that interest rates need to rise at least half a percentage point above the “neutral” estimate of 2.4% for the economy to deliberately fall below estimates for long-term potential growth of 1.8%. to cool down and eventually pull inflation back down to its 2 percent target.
But, as Morgan Stanley’s team points out, that means effectively cutting growth in half from here, and then tapping and nudging the controls to keep momentum from pushing it over the edge.
“Any such slowdown must significantly increase the likelihood of a recession, even if a recession isn’t the base case — which isn’t the case for us,” it told clients.
The US bank expects the 2-10 yield curve to invert this time around – ending the year down 35 basis points – but no recession to follow.
Why? One of the things it cites is the disappearance over the past decade of the so-called “maturity premium” on longer-dated bond yields — additional indemnities that investors used to demand to cover the risk of things going wrong overnight over many years keep the same bond.
The reasons for the disappearance of this term premium vary – from the impact of the Fed’s years of bond-buying to almost a decade of below-target inflation.
But without these term premia today, a normal inversion of the yield curve over the cycle, which simply depicts how the Fed will tighten, control inflation, and then ease again, risks inverting the Treasury curve as well. In other words, chances are the inversion isn’t what it used to be.
An alternative view, of course, is that the Fed is just talking hard, hoping that market fear alone is enough to ensure it doesn’t have to carry out the aggressive moves of the 1990s.
Invesco strategist Kristina Hooper likens it to how she often tries in vain to deal with her wayward teenagers and believes the Fed could only warn for effect – “speak loud but hope big action won’t be necessary. “
“Sometimes tough talking can be enough.” The author is the finance and markets editor at Reuters News. All views expressed here are his own
(by Mike Dolan, Twitter: @reutersMikeD)
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