Fed leaves rates unchanged (again), but leaves option open to hike rates (again)
As expected, the Fed left rates unchanged (while leaving the option open to hike in the future), recognizing that the recent increase in market rates should act to cool the economy.
Markets, though, seem pretty sure that July was actually the last hike in this cycle – pricing just a 25% chance of another hike by January – which helps explain why stocks and bonds rallied into the close on Wednesday.
The last rate hike typically precedes recession by a year on average…though a soft landing is possible
If the cycle is over, one concern is that recessions almost always follow a rate hike cycle, and this cycle has been faster and larger than most.
In the chart below, we look at the fed funds rate (red line), recessions (shaded areas), and how long between the Fed’s last hike in a cycle and the start of recession (red arrows).
Since the 1990-91 recession, it typically takes about a year from the last hike to the start of recession (however, before the 1980-81 and 1982 recessions, it was just 2 months).
Importantly, there was also the mid-90s soft landing, so that’s another (strong) possibility this time (especially given continued labor market strength and resilient consumer spending).
So far, we’ve made it 3 months from the last hike without a recession (it’s a start!).
Markets tend to lead the Fed and recession
If we have a recession, though, rates will likely come down more, and faster, than markets expect.
Since markets are forward-looking, 2-year rates (chart below, blue line) and 10-year rates (green line) tend to turn down (arrows) before the Fed cuts rates and before recession, recognizing that the Fed will need to cut rates to support the economy.
Of course, even if market rates do fall, it doesn’t mean a recession is guaranteed, since they also fell during the mid-90s soft landing (green arrow). So far, though, market rates remain close to their recent highs.
Treasury yields should probably fall from here
Even if we get a soft landing, Treasury yields and the fed funds rate should probably fall from here (which we looked at a month ago), especially since the Fed’s own dot plot calls for 275bps in cuts over the next 3 years, which is hard to square with near-5% yields on 2-year and 10-year Treasuries.
If we see yields fall, that should help support valuations, especially if a soft landing is keeping earnings growing.
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