Since the Financial Crisis, there has been one constant in the capital markets – an accommodative central bank and low interest rates. Today those days are starting feel long in the tooth. The 10-year treasury crested past 3% in April and investors expect a more hawkish Fed president to move away from the easy money policies of his predecessors. But normalizing interest rates is no easy task. The US deficit is ballooning and treasury spreads are flat as a pancake.
HiddenLevers recently analyzed possible rising rate scenarios and the current state of the Federal Reserve. This post will summarize our potential good, bad and ugly outcomes for the US economy and Fed policy.
The Good: Old Normal
If Powell wants to keep the party going, a couple of things will need to go his way. First, the business cycle will need to continue another couple of innings. Continued GDP growth would pull up 10-year treasury yields, giving Powell the room to normalize rates and avoid the dreaded inverted yield curve. Make no mistake though, yield curve inversion is a symptom not a cause of recession. Areas outside of the Fed’s control will need to move in the right direction for painless interest rate normalization.
The Bad: 1987 Crash Repeat
We are closest to this scenario. If the Fed becomes aggressive with rate hikes and pierces the asset price bubble, fixed income would become more attractive, moving investors away from equities. The S&P would contract and GDP growth would decline. This is not a recession scenario (the economy is still growing), but there would be a correction in the equities market.
The Ugly: Inverted 2/10 Yields
If Powell elects to continue hiking the short end of the yield curve and economic growth stagnates we could see a yield curve inversion. This is a bearish signal, and research supports that yield curve inversion is a near perfect predictor of future recession. In this scenario expect negative GDP growth and a steep decline in the equity market.
How far away are we from this scenario? Right now, the spread between 2 and 10 year Treasuries is around 50 basis points. This means if the Fed were intent on even two rate hikes for the remainder of the year, this would bring us to a flat or possibly inverted yield curve. With little room to move, these rate hikes would bring us closer to a possible market correction.
Rising Rates with no inflation?
You might think there is something missing from our analysis, after all the Fed’s mandate is to meet inflation and unemployment targets. There is little doubt the US has reached full employment, but why would the Fed raise rates if inflation remains muted? With the New Fed Hawks led by Jerome Powell there’s a heavy assumption there will be strong GDP growth and naturally inflation will follow. Powell may be correct, recent news shows evidence of accelerating consumer prices. Expect Powell to take the Fed’s target of 2% inflation seriously and raise rates more aggressively in anticipation of inflation.
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