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The Fed’s Flirtation with Recession
The Federal Reserve has found itself in a potential race to increase rates before a recession hits. Director of Short Duration Fixed Income Peter Yi, CFA, examines what this means for the bond market.
Investors are starting to turn their sights from an inflation watch to a recession watch, thanks to the Federal Reserve's aggressive rate hikes. Investor expectations for a recession have recently shifted meaningfully higher, with even some not questioning if there will be a recession, but how deep. We believe that if the Federal Reserve doesn't get the inflation battle right today, it may find itself raising rates during a recession later. Let's take a closer look.
The Fed is well underway on their aggressive tightening of monetary policy and investors are navigating high inflation and recessionary fears that's prompting continued volatility. Just prior to the Fed's June meeting, the market quickly priced in a 75 basis point rate hike despite Fed Chairman Jerome Powell and other Fed officials providing guidance for a more modest 50 basis point increase.
The more aggressive rate hike sends a clear message that the Fed is looking to re-establish its credibility to address uncomfortably high inflation, but at the cost of credibility of its forward guidance. Still, investors think the Fed will be bold to fight inflation. It's five-year breakeven inflation rates have drifted down to around 2.85% from its peak of 3.75% earlier in March.
While Powell warned not to expect 75 basis point increments to be common, he also did not rule out an increase of an entire percentage point when asked during congressional testimony last week. Further rate hikes of that magnitude are not our base case. However, we interpret these latest developments as indicating a desire by the Fed to front-load additional tightening to lower the probability of increasing rates during a recession.
Furthermore, Powell acknowledged that bringing down inflation without driving up joblessness presents a significant challenge. It's clear that we're navigating an extraordinarily uncertain environment where many of the inflation drivers are outside of the Fed's control. It has become increasingly more difficult to predict the persistence of inflation and the magnitude of rate hikes needed.
With inflation at a 40-year high and investors believing that the Fed will double its policy rate to 3 and 1/2 by the end of the year, some investors are even starting to price in a series of rate cuts as soon as the end of next year. Going forward, investors should expect continued volatility leading to exaggerated moves and bond yields the longer inflation stays elevated while recession concerns continue to rise.