At the start of the year, investors and policymakers commonly used the term “soft landing” to describe the state of the US economy. Despite the most aggressive Federal Reserve (Fed) rate hiking cycle since the 1970s, growth remained robust while inflation moderated. The possibility that central bankers might have managed to balance inflation without hurting growth initially pushed recession forecasts out to 2024.
However, a banking crisis in both the US and Europe has led to a sharp tightening in financial conditions as lenders strike a cautious tone and hold back on extending credit to the real economy. This was reflected in the latest Senior Loan Officer Survey from the Federal Reserve, which showed a sharp tightening in lending standards to US firms. If credit to the economy is choked off, then the ripple effects from recent bank failures could well pull forward the timing of any recession and potentially bring the Fed’s rate hiking cycle to a premature end.
Following the latest Fed meeting on March 22, the Chair of the US Fed, Jerome Powell, acknowledged that a credit crunch would have significant macroeconomic implications that could potentially influence the trajectory of Fed policy. However, he added that “rate cuts are not in our base case.” Despite the Fed Chair’s comments, market pricing of the pathway for the Fed Funds rate has shifted markedly in the last few weeks. Investors now anticipate that a Fed pause is imminent and that they will begin cutting rates as soon as September 2023 as growth slows and inflation continues to abate.
As the Fed ponders its next step, investors should be mindful that the window of opportunity that has emerged in fixed income may slam shut quickly. In prior recessions, as growth has stalled, the Fed has lowered rates, and bond yields have quickly followed suit.
