Economic outlook: Fed versus bond investors
What’s the likelihood of recession in the next 12 months? If you ask the Fed, there’s little near-term risk of such a significant downturn. But if you ask bond-market investors, the odds of being hit with a bleak economy in the near future are well over 10 times higher than what the central bank projects.
How can there be such a huge discrepancy between two historically reliable indicators of economic health? Each is based on a different type of data. The Fed focuses on “hard data,” which represent quantifiable economic developments—determined by calculating actual activity, such as number of employed people, wage levels and consumer spending. Meanwhile, the bond market is influenced by “soft data,” which denote how Americans perceive the economy—based on surveys conducted by various organizations.
Data: Hard versus soft
Recent hard data, while easing from the robust pace of 2018, still broadly point to continued expansion and minimal risk of near-term recession. Specifically, domestic growth and labor-market data remain solid. The St. Louis Fed’s recession probability model captures this, showing just a 2.7% probability of recession over the next annual period, as of April 2019 (updated June 4, 2019: https://fred.stlouisfed.org/series/RECPROUSM156N).
In contrast, deteriorating soft data (such as business- and consumer-sentiment readings) have driven investors to push bond prices higher (interest rates and prices move in opposite directions) in anticipation of the Fed changing its outlook and subsequently cutting its key lending rate in order to help boost the economy. The Fed must walk a fine line as it transitions between rate hikes and rate cuts—providing enough stimulus to prop up growth, inflation and risk assets while also maintaining financial stability, avoiding asset or credit bubbles.
Federal-funds rate: Hike, cut or hold
In December 2018, the Fed hiked its interest rate for the fourth time that year despite the faltering resilience of the U.S. economy in the final quarter of 2018. But the New Year brought a different story: Domestic growth and labormarket data remained solid, yet the global growth outlook was weakening and there was a heightened focus on below-target inflation. By the central bank’s meeting in March of this year, it provided a much softer assessment of the 2019 outlook and put its rate-hike cycle firmly on hold.
The bond market has consistently contrasted with Fed forecasts for some time. Recently, as trade negotiations took an unexpected turn for the worse, the bond market went beyond pricing in an end to the rate-hike cycle to pricing in a full-on rate-cut cycle—as evidenced by the recent sharp jump in prices.
The Fed’s recent communication showed its data-dependency and continued comfort with current monetary policy. As such, we believe the Fed will refrain from cutting interest rates until there is hard evidence of a direct hit to economic data or a dramatic stock-market plunge. Our biggest worry is that crumbling sentiment may suppress job creation, which would crimp consumer spending. If growing trade frictions impact data by mid-summer, the central bank may cut rates at its July and September meetings. But today these are unknowns.
What we do know is that the Fed rarely moves in isolation; once the first rate cut happens, the market tends to expect further cuts. And whether the Fed stays on hold for an extended period or cuts rates in the near term, we are confident that we have reached the peak federal-funds rate for this cycle.
Glossary of Financial Terms
Federal-funds rate: The federal-funds rate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight in the U.S.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.
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