Did the market get ahead of itself with hopes of soft landing?

Risk assets sold off significantly a couple of weeks ago – part of an overall decline across the market in the last month or so – as inventors reassessed the state of the economy and the path of future interest rates. Economic data continues to show a resilient US economy, sparking a sell-off in the bond market with yields rising markedly. 

The US 10-year treasury rose close to a 16-year high, the 10-year UK gilt yield hit its highest level since 2008, and the German 10-year bund reached its highest yield since 2011. 

Previously, the market had anticipated that interest rate hikes were all but over, following a brutal 2022 that saw the fastest tightening cycle in recent memory. The optimism came amid the continued fall in inflation this year. Risk assets advanced accordingly, with the tech-heavy Nasdaq, particularly sensitive to interest rates, even banking its strongest first half of the year since 1983.

So, is there logic behind this selloff, or is it a minor blip? Or did the market really get ahead of itself, and more monetary tightening is very much on the menu?

Inflation is stickier than people think

We put a piece out only a few weeks ago cautioning the market against concluding that the pain of the tightening cycle was over. 

One of the central points was the fact that inflation could be stickier than a lot of people realise. There are a few reasons for this, but the first is understanding exactly what the much-discussed CPI number actually means. 

CPI is measured on a year-over-year basis, so while the fact it had plummeted down to 3% was positive on the face of things, a closer look reveals that this could imply things are cooling down quicker than they really are. Readings from twelve months ago were highly elevated, with inflation pushing double digits. Dropping these readings out was always going to mean falling inflation in the headline number. 

While July’s reading since came in at 3.2%, 20 bps higher than the previous month, there is more reason to be sceptical. The core number, which strips out volatile items such as food and energy, has been far sticker than the headline number. This is especially important because the Fed tends to lean more on this as a gauge of how monetary policy is doing. The next chart contrasts how quickly the headline number has come down compared to the core metric.

The Federal Reserve even warned that there is “significant upside risk to inflation” in its minutes published last Wednesday, albeit with several officials seeming to be confident that more rate rises would not be required. 

Looking beyond the US, given the bond sell-off occurred across the market, shows that things are even murkier internationally. Inflation in Europe is, for the most part, significantly above what is being seen in the US. 

Taking note of our discussion earlier on core vs headline, when we look at the core inflation rate in the euro area, the difficulty that the ECB has had in pulling inflation down is laid bare. 

Recession possibility

For so long, the baseline assumption was that a recession was inevitable, such was the scale of the interest rate rises. To conquer inflation, pain was necessary – there was no way to avoid it. The Federal Reserve even acknowledged this as recently as March, meeting minutes indicating it forecasted “a mild recession starting later this year, with a recovery over the subsequent two years”. 

This position then flipped last month, with Fed chair Jerome Powell asserting that “given the resilience of the economy recently, (we) are no longer forecasting a recession”.

But regardless of the pared back forecast – and things have undoubtedly brightened in the last nine months – the reality is that T-bills are now paying above 5%, following years of interest rates being close to zero. That is an immense strain on global liquidity, and why the elusive “soft landing” was deemed by some to be unrealistic. 

Additionally, we know that monetary policy notoriously operates with a lag. Throw in the fact that wages are showing upward pressure and unemployment is close to half-century lows, and the full effects of the liquidity drain could yet be felt. 

On this fear of recession, the yield curve is oft-referenced as a canary in the cold mine. If it inverts, a recession tends to follow, or so goes the theory. In fact, there have been a few cases where the curve has inverted and a recession has not followed; yet, when the curve has inverted for a period of longer than six months, a recession has followed every single time – at least in the last 40 years. 

Currently, looking at the 10Y-2Y curve, the curve is at its deepest level of inversion since 1981.

Regarding timing, the alarm bells are also loud. Recessions have followed between 13 and 21 months after the curve inverts. The curve has been inverted since July 2022, meaning it is now month 13. 

Recalibration

Ultimately, the market seems to have recalibrated somewhat off the borderline-assumption that a soft landing would happen. As mentioned above, inflationary pressure remains high while uncertainty over the full effects of the tightening persists. 

In looking at how rate forecasts have moved between now and a month ago, the market is certainly not as dovish as it was. We have backed out the probabilities implied by Fed futures for interest rates at the first Fed meeting of next year (January 2024) in the next chart. 

It shows that there is currently a 25% chance of rates above the current level, compared to 13% a month ago. Looking at cuts, one month ago the market had a 42% chance of rates being below the current level in January next year, whereas the probability is now 23%. 

The dip in risk assets off the above recalibration, in response to the continued strong data and more hawkish Fed comments, highlights how sensitive the markets are to the macro situation. It also signifies that, without doubt, inflation still remains a grave concern, while the soft landing is far from guaranteed. 

Having said that, the soft landing once seemed a pipe dream, and while this piece preaches caution, it would be remiss not to acknowledge that the outlook is significantly better than it was at the turn of the year.