The history of Fed rate hike cycles and recessions is clear. The FOMC causes every recession by fighting inflation, that’s its mandate. So what makes them think this time that they can generate a soft landing with the most convoluted combination of debt, demographics and geopolitics we’ve seen, along with a wave of inflation from costs never seen for 40 to 50 years? We suspect, the simple fact that if they told you what they really think, the stock market wouldn’t appreciate it very much. And they care about the financial terms. The first chart shows the US 3-month (green) and 10-year (orange) yields along with the shaded periods when the US economy was in recession. We always see the yield curve (3M-10Y) invert before a recession. We are very far from it today. Based on the latest Fed forecast we saw last week, the curve could invert in early 2023, suggesting that the recession will have an impact in 2024 or 2025. The next few years for stock markets could be a challenge.
When we look at the yield curve, we do so because it has a direct impact on bank profitability. Everyone should know that falling interest rates are generally negative for net interest margins (NIM). Banks borrow short term and lend long term as a rule. The lower the NIM, the more risk averse banks are, leading to less credit in the market and ultimately lower growth rates.
The cause of today’s inflationary stress has little to do with the traditional business cycle, a rate hike is unlikely to generate a soft landing. The economy is much more fragile from a credit point of view, which complicates the fight against inflation. But bank balance sheets are sound and systemic risk is low. But rates probably won’t be able to rise too much. We better hope inflation isn’t too sticky.
The recent National Association of Business Economists (NABE) survey of inflation in the United States is expected to exceed 3% by the end of next year, according to the majority of economists surveyed by NABE. Some 78% of panelists forecast annual growth of 3% or more in consumer prices, with 36% of forecasters indicating that inflation is “very likely” to stay above that level. Meanwhile, 77% of panelists said monetary policy was too stimulative. The NABE survey was conducted before the Federal Reserve raised interest rates last week for the first time since 2018, but the move was widely anticipated. The survey of 234 NABE members was conducted from March 1-8. This is well above the Fed’s forecast, which puts them WELL behind the curve.
A look at the tracking NIMs for select US banks and the top 5 Canadian banks shows that the current NIMs are the lowest we’ve seen in decades. The likelihood of the FOMC not having the tools to generate a soft landing is very high.
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