Wall Street, Main Street, and the Fed now appear in agreement: a recession is coming
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The recessionary story is a tale as old as August 2022 for this business cycle, at least according to the Bloomberg 1-year United States recession probability forecast index. In August, a majority of those surveyed predicted a recession would occur in the U.S. within the next year. For their part, consumers have been warning the economy will deteriorate since June 2021. Since that point, the consumer sentiment index from the University of Michigan has been in relative freefall.
The index hit an all-time low of 50 in June 2022, which was impressively pessimistic considering the index has existed since 1980. It now stands at just 62, which is lower than 93% of all historical readings. However, it was only two weeks ago that the members of the Federal Reserve’s Federal Open Market Committee (FOMC) finally agreed a recession was coming this year.
According to the University of Michigan’s consumer sentiment reading, the overall outlook by consumers deteriorated from a reading of 67 in January to 62 in February. The study authors indicated:
“Our data revealed multiple signs that consumers increasingly expect a recession ahead. While sentiment fell across all demographic groups, the declines were sharpest for lower-income, less-educated, and younger consumers, as well as consumers with the top tercile of stock holdings. All five index components declined this month, led by a notably sharp weakening in one-year business conditions.”
As the Fed continues to fight inflation, it looks like Main Street is listening. Consumer price expectations for the next year hit their lowest level since April 2021 and were 3.6% in February. The high-water mark of 5.4% for the index was set in March 2022, which notably was not too far off from the 5.0% reality that occurred.
Likewise, new personal consumption expenditures (PCE) revealed consumers are starting to spend less as they prepare for uncertainty ahead. Consumer spending adjusted for prices fell 0.1% for the month after surging 1.5% in January. As a result of the decrease in conjunction with other macroeconomic headwinds, headline inflation decelerated both month-over-month from 0.6% in January to 0.3% in February and on a year-over-year basis from 5.3% in January to 5.0% in February.
A bright spot for consumers for the month was in increases of their income (+0.3%), disposable income (+0.5%) and savings rate (+0.2%) month over month. However, the overall savings rate of 4.6% remains well below the 6.8% Bloomberg estimate for the baseline savings rate. That implies consumers are spending more of their savings to compensate for inflation.
According to the Bloomberg recession probability forecast, which is a survey of banks and reputable forecasters of the probability of a U.S. recession within the next year, 65% of participants expect a recession. The index has only been higher in January 2023, 2008, and 2020. With that view in mind, the market is again fighting the FOMC’s view of interest rates.
Using the 1 mo. USD-SOFR CME Term forward curve as a proxy for market rates, it’s clear the market is expecting interest rates to fall much faster than the FOMC projects. Relative to a week ago, the market is trending closer to what the FOMC expects but is still dramatically undershooting its expectations. The deviation suggests the market believes a potential recession will occur by the middle of 2023 and the Fed will be forced to cut rates to combat the economic downturn. Inflation would presumably fall in this scenario as consumers lose their jobs and cut spending.
Based on the median projection provided by FOMC members in the summary of economic projections released by the Federal Reserve on March 21, 2023, FOMC members are now projecting a recession. As of March 31, data from the Atlanta Fed suggested the economy grew at a 2.5% annualized rate in the first quarter of 2023. Meanwhile, FOMC members projected the economy will grow by just 0.4% in 2023 on an annual basis. With these two projections in mind, FOMC members are therefore expecting GDP to decline by an average of 0.7% over each remaining quarter in 2023. In other words, FOMC members are projecting a recession. Unlike the market though, FOMC members still expect rates to remain elevated until at least 2025, as shown in the graph above.
For the first time over the last year, the market, consumers, and the FOMC are all broadly in agreement that the U.S. economy will hit a recession this year. The major discrepancy between the market and FOMC is how inflation, and thereby interest rates, will react. Federal Reserve Chair Powell has reiterated to the market many times that the FOMC and Fed will keep interest rates elevated until inflation is under control, even if an economic downturn occurs. The market, on the other hand, seems to think inflation will cool dramatically in the face of a recession and the FOMC will cut interest rates quickly to boost economic output.
As of right now, annualized PCE of 5%, although lower than January, is still far too high relative to the Fed’s stated 2% target. If inflation remains persistently elevated, the FOMC will be expected to keep interest rates elevated in response. If that’s true, we can expect treasury yields, swap rates, and corporate debt yields to increase until they match a curve similar to the FOMC’s forecast. On the other hand, if inflation falls below consumer expectations and towards the 2% FOMC target, whether due to a recession or other economic changes, then the market curve may be more accurate than FOMC projections.
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