Possible pause

The minutes from the May meeting of the Federal Open Market Committee signal that the central bank wants to quickly and aggressively hike rates at the next couple of meetings to allow officials the ability to pause to assess the effects of policy firming on the economy, inflation and financial markets. This reduces our subjective odds of a recession in the next 12 months.

The minutes provided some clarity on the Fed’s plan. They showed that “most” Fed officials saw 50-basis point rate hikes as appropriate at the next two meetings. There was mention of a potential pause of further rate increases later this year. The minutes noted that an “expedited” tightening would position the Fed well later this year to assess the effects of policy firming and determine if any policy adjustments were needed.

A pause would improve the odds that the Fed engineers a soft landing. Previously, it appeared the Fed was going to hike until something broke—either inflation or the economy. The minutes were lighter on the inflation discussion than in March with only 66 inflation references compared with more than 80 at the prior meeting. There was no reference to recession.

On the balance sheet, a number of officials supported eventually selling mortgage-backed securities. The May minutes noted a “number” of committee members wanted to sell MBS down the road, which is more than the “couple” or “few” that supported this at prior meetings. One reason to sell MBS is to accelerate the return of the Fed’s balance sheet to mostly Treasuries.

Hitting a wall

The U.S. 10-year Treasury yield has jumped over the past year but appears to have hit a wall as markets are repricing their expectations for the path of the target range for the fed funds rate as the U.S. economy cools and there are signs that inflation has peaked.

Some of the repricing of expectations for the fed funds rate is attributable to recent comments by a regional Fed president that a pause is possible in September. This doesn’t eliminate hikes over the next several meetings, but markets have dialed back the amount of tightening they anticipate.

Fed comments aside, the U.S. economy has softened, and the economic data have been coming in weaker than anticipated.

The Citi U.S. Economic Surprise Index has dropped recently as some of the key economic data came in weaker than the consensus expected. The index has turned negative, meaning that the data have been worse than the consensus anticipated. A negative index doesn’t increase or signal a recession; there have been plenty of instances where it was negative and the economy avoided a recession.

The U.S. isn’t alone. The Citi Economic Surprise Index in China is also negative, and although it is positive in the euro zone, it has been declining.

Markets appear to be focused on the U.S. economic data’s second derivative. There are a few ways to look at the economic data, including the level and the first and second derivatives. The first derivative is the rate of change in the data, including employment, industrial production and retail sales, showing whether it has risen or declined. The second derivative tells us whether growth is accelerating or decelerating. Growth in the U.S. has clearly slowed, and this has contributed to concern about a recession, particularly as the economy hasn’t digested the significant recent tightening in financial market conditions.

What if?

The economy has clearly slowed but a recession isn’t guaranteed. A pause by the Fed would increase the odds that it can pull off a softish landing, but what if it can’t. The corporate bond market wouldn’t be immune to a recession, but high-yield corporate bond spreads would likely peak lower than in the past few tightening cycles. In fact, in our next-cycle recession scenario, high-yield corporate bond spreads peak around 900 basis points in the next recession.

The peaks of the last four recessions ranged from a low of 1,100 basis points in 2002 to a high of 2,000 basis points during the Great Recession.

There are a number of factors that would determine the peak and how quickly corporate bond spreads widen during the next recession, including the catalyst of the recession, severity of the downturn, amount of financial market stress, and liquidity conditions.

If a recession occurs soon, it would likely be mild because there are no glaring imbalances in the economy. Also, defaults will likely increase by less than in the past several economic downturns. Liquidity is a wild card. All of these are sensitive to the catalyst of the recession.