Investor concerns that the US economy is overheating are giving way to recession jitters as analysts fret the Federal Reserve could stifle growth with its rapid tightening of monetary policy.
Markets are pricing in an aggressive path for Fed rate rises in the coming months while also signalling expectations that the central bank will then change course next year and begin cutting rates.
“We have seen the consumer getting squeezed by the higher cost of living and by monetary policy, which could lead to a consumer-led recession,” said Erin Browne, portfolio manager at Pimco.
Economic reports released over the past two weeks have heightened the sense of uncertainty. Key surveys on the US services and manufacturing sectors from the Institute for Supply Management showed corporate America is cutting back on hiring. Weekly figures on unemployment claims have also pointed to slowing momentum. However, the monthly employment report on Friday pointed to robust hiring, while inflation in May reached its highest level since late 1981.
Jan Hatzius, chief US economist at Goldman Sachs, said there was “no doubt that a labour market slowdown is under way”, adding that “job openings and quits are declining, jobless claims are rising, the ISM employment indices in manufacturing and services have fallen to contractionary levels, and many publicly traded companies have announced hiring freezes or slowdowns”.
Still, Hatzius said that “fears of an imminent US recession have abated somewhat” after figures showed the US economy added 372,000 jobs in June, widely exceeding expectations.
The June jobs report also bolstered expectations that the Fed will boost rates by 0.75 percentage points in late July, which would bring the central bank’s benchmark interest rate to a range of 2.25 to 2.5 per cent from 0 to 0.25 per cent at the beginning of 2022.
The rate increases have already pushed up US borrowing costs, sparked strong selling in the corporate bond market, ignited the worst sell-off in Wall Street equities for the first half of a year since 1970 and helped send the dollar surging against its peers.
The combination has led financial conditions to reach their tightest level since the early days of the coronavirus crisis in 2020, according to an index collated by Goldman. Tighter financial conditions typically feed back into the broader economy, weighing on output.
Even after the strong jobs report, a running economic forecast by the Atlanta Fed is pointing to output contracting at an annualised rate of 1.2 per cent in the second quarter of this year, following a 1.6 per cent annualised fall in the first quarter.
Andrew Hollenhorst, chief US economist at Citigroup, noted that while the strong June jobs report “pushes strongly against the view that the US economy is in recession or imminently will be”, the Fed’s focus on “slowing the economy to tame inflation materially raises the risk of recession in 2023”. He added that “the very-tight job market may make it that much more difficult to obtain a soft landing”.
The US government bond market is also flashing warning signs. Two-year Treasury yields are trading at about 0.04 percentage points higher than those on 10-year notes. The so-called inversion of the yield curve, in which yields on shorter-dated securities are higher than their long-term counterparts, is typically seen as a gloomy sign for the economic outlook.
A US recession has followed every yield curve inversion within six months to two years over the past five decades. The first yield curve inversion this year in March would put the US on track for a recession by the start of 2024 at the latest, a prediction also reflected in other parts of the market.
“At this point in time there’s a lot of uncertainty. Investors have very different probabilities on whether the recession is going to be in the next 12 months or 24 months,” said John Madziyire, head of US Treasuries at Vanguard. “But what has definitely happened is there has been a deterioration in consumer sentiment and business sentiment.”
This more downbeat outlook is also reflected in expectations for Fed rate rises. Trading in the futures market suggests investors expect the Fed to raise its main rate to a high of about 3.5 per cent by February 2023, but then begin to cut rates back to under 3 per cent by November that year.
A report this week on US inflation will help shed further light on the expected trajectory of Fed rate increases. Wall Street economists expect the annual rate of consumer price growth to have risen to 8.8 per cent in June, from 8.6 per cent in May, according to a FactSet survey.
“With last week’s employment report showing still-solid payroll gains amidst a record tight labour market, barring a meaningful disappointment this week on inflation, the Fed should be well on track to hike by another [0.75 percentage points] at its upcoming meeting,” Deutsche Bank economists said.
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