Bonds

Inflation, a banking crisis and the remnants of COVID-19 related issues make forecasts more difficult than usual. Heading into next week’s Federal Open Market Committee meeting, a division remains between those who expect this to provide the last of the quarter-point rate hikes and those who see another coming.

Recession also splits economists, with some expecting a downturn while others do not.

The Fed, which has touted “flexibility and optionality,” will be data-dependent in determining monetary policy, said Subadra Rajappa, head of U.S. rates strategy at Societe Generale. “A hike in May and policy ‘on hold’ for the remainder of the year seems likely, unless fundamentals deteriorate meaningfully in 2H, warranting a policy pivot.”

Ryan Swift, U.S. bond strategist at BCA Research, agrees. “We see the Fed pausing after one more 25 basis point rate hike,” he said. BCA doesn’t forecast rate cuts in 2023.

The Fed’s “job is not quite done,” said Emin Hajiyev, senior economist at Insight Investment. He also sees one hike and then steady policy for the remainder of the year “to allow for the lagged effects of its hikes to work through the real economy.”

The tightening could be “loosening labor market conditions,” he said, pointing to job openings, which are the lowest since May 2021, and moderation in the pace of job creation.

But, Scott Wren, senior global market strategist at Wells Fargo Investment Institute, sees 25 basis point increases at the May and June FOMC meetings. The “real question,” he said, “is how long will rates stay there?”

With getting inflation back to its target the Fed’s main goal, Wren said, the Fed “will not ease rates until it is clear the goal will be achieved.” He also rules out any rate cuts in 2023.

“Our expectation that the Fed will not cut rates this year is a key reason we believe the economy will slow further and eventually tip into a recession later this year,” he said.

But economists at investment firm abrdn expect the fed funds rate to sink back to zero by 2025, given recent history. “The U.S. has cut cycles following the last four recessions back to 1990,” according to the report’s authors Abigail Watt, research economist, and Luke Bartholomew, senior economist.

Policy rules also suggest a return to the zero-bound, they said. “History also suggests a cutting cycle of this magnitude is consistent with how policy makers respond to recessions.”

As for recession, abrdn expects one to begin in the third quarter, taking “2% off U.S. GDP, push[ing] unemployment up to 6%, and tak[ing] core PCE inflation to 1%.”

Although recession is not his base case, Gautam Khanna, head of U.S. Multi Sector Fixed Income at Insight Investment, said, “we see risks as heavily skewed to the downside.”

Should a recession occur, he said, it “will likely be relatively shallow as the economy is generally starting from a position of strength and consumer and corporate leverage is historically conservative.”

In addition to the inverted yield curve, which “has been a solid, although not entirely foolproof, predictor of a recession,” Khanna said, the Leading Economic Index also signals a near-term recession.

While LEI has “been a solid predictor of a recession,” and is signaling one, he suggests taking a closer look. “The signal from elements such as consumer expectations, building permits and manufacturing orders are perhaps worth assigning more weight to but currently offer some mixed signals. But, similar to the yield curve, the index should not be dismissed out of hand.”

In the event of a shallow recession, Khanna said, “we believe credit markets are relatively well placed as long as investors pick credits wisely and responsibly.”

After a decade where the Fed struggled to get inflation up to 2%, David Kelly, chief global strategist at JPMorgan Funds, said, “the inflation surge of the past two years has completely changed the Fed’s focus. Moreover, it has also altered the outlook of many economists and strategists.”

For one, a number of economists “argue that inflation pressures will be permanently stronger going forward than in the decade before the pandemic.”

Yet, Kelly believes “most of the inflation surge is, (or rather was), transitory,” and a look at “the forces that led to low inflation in the last decade suggests that most are still operating beneath the surface, implying that when transitory inflation has fully ebbed, what’s left should look pretty close to pre-pandemic inflation.”

Even if inflation falls to 2% and a recession occurs, Kelly said, “we do not expect a return to the zero bound for the federal funds rate. The Fed may, at least, now appreciate the damage done by sustaining that policy for so many years after the financial crisis. Similarly, the federal government is unlikely to be as generous going forward both because of divided government in the short-run and the recognition that recent inflation was stoked, in part, by a too-powerful fiscal response to the pandemic.”

The U.S. may be witnessing “a new economic phenomenon,” according to University of Central Florida Economist Sean Snaith: A “job-full” recession.

“Unlike past recessions, the labor market has kept growing in the face of other economic losses — something that’s unprecedented,” Snaith says.

A full-blown recession remains on the table, he said. “The Federal Reserve’s aggressive interest rate hikes and fears surrounding recent banking collapses are adding pressure, which has been building as inflation has eroded consumers’ purchasing power.”

“Many indicators suggest that we are on the brink of or currently in another relatively short and shallow recession,” Snaith said. Unemployment will climb later this year, and continue through 2025, he predicts, although it won’t be as bad as after the financial crisis or COVID slowdowns.

He sees inflation near 2% by the end of next year, “thanks to interest rate hikes and” a mild recession.

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