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Risks to the Soft Landing

Markets expecting no Fed hike today, but see Fed still projecting another hike

Markets are waiting on the Fed’s announcement this afternoon. Since the expectation is that the Fed keeps rates unchanged this month, the focus is on changes to the Fed’s forecast for rates from here.

The Fed is expected to maintain its forecast for an additional rate hike (in November or December) and to reduce the amount of rate cuts planned next year (pricing in this “higher for longer” path helped push 10-year Treasury rates to 4.35% – a 15-year high).

Markets only see a 40% chance that extra hike eventually happens, but the Fed wants to maintain that option (especially if oil prices keep rising).

Markets coming around to soft landing

The economy’s continued resilience is the main reason why the Fed may end up hiking again. It’s also why the expectation the Fed pulls off a “soft landing” (green line) has become the dominant narrative over recession (red line).

Soft landing vs recession

Risks to soft landing: student loans, government shutdown, and UAW strikes

So what could derail the soft landing? Goldman Sachs recently highlighted three key risks (chart below).

1. Resumption of student loan payments (October 1)

43 million Americans have to find $200-$300/month on average for their loan payments. Since Goldman estimates about two-thirds of that will come from reduced spending (the rest from reduced saving), it will shave about 0.5 percentage points off Q4 GDP growth.

2. Government shutdown (October 1)

It feels like just last week the debt ceiling standoff was resolved. Now the battle is funding the federal government for the next fiscal year.

Often, when the two sides can’t agree on a full-year deal, short-term funding (as little as days’ worth) is passed so the government stays open while negotiations continue. Now, however, House Speaker McCarthy’s short-term funding proposal was just canceled, lacking support.

Without a deal by month’s end, the government will shut down. Goldman estimates a 2-3 week shutdown, with each week reducing Q4 GDP growth by 0.2 percentage points (mostly due to reduced government spending).

3. United Auto Workers (UAW) strike

The UAW work stoppage began last Friday, with about 10% of 146,000 UAW members on strike. If a deal isn’t reached by Friday, the UAW is threatening to expand the strike. The union is looking for a 30+% pay raise over 4 years, reinstating cost-of-living adjustments, and a shorter workweek.

Goldman estimates each week of strikes reduces economic output by 0.05-0.10 percentage points (relatively recent strikes have been as short as 3 days or as long as 54 days).

This is already impacting Q3 GDP growth and will only impact Q4 if the strike continues into October.

Developments weighing on Q4 growth

Despite these headwinds to growth, GDP is expected to remain positive in Q4

For now, only the restart of student loan payments is sure to have a significant impact on economic growth since the government and the UAW could strike deals at any moment.

Still, even if a government shutdown happens and the strikes continue, as long as they’re relatively short-lived, economists expect Q4 GDP growth to remain positive (and Q3 is off to a strong start). So the Fed could still pull off the rare soft landing, which would prevent a drop in earnings and help valuations.

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