These fears sent equity markets worldwide on a roller-coaster ride, with the Japanese stock market selling off by 12% in one day while the Nasdaq composite index entered correction territory.
More recently, however, U.S. equity markets have recouped their losses amid economic data that point to continued economic growth and moderating inflation.
Market Volatility & Fed Confidence
So, what accounts for the heightened market volatility of late?
My take is that confidence in the Fed was undermined when it acted belatedly in addressing accelerated inflation during 2021 and 2022. It was then forced to play catch up when it tightened policy from the spring of 2022 to mid-2023, which increased the risk that it could tip the economy into a recession.
After keeping monetary policy on hold for more than a year, Chair Jerome Powell signaled at the Jackson Hole Economic Symposium that the time had come for the Fed to begin easing monetary policy at the September Federal Open Market Committee (FOMC) meeting. The reason: The Fed is more confident that inflation will approach its 2% annual target, while evidence mounts that the job market is softening.
Powell did not commit to what the pace of easing would be, and he reaffirmed that the Fed would be "data-dependent" in balancing the risk of inflation and recession. However, some Fed officials have indicated that they favor easing in increments of 0.25%.
By comparison, analysts at many Wall Street banks tore up their interest rate forecasts after the July payrolls report was released and wrote new ones. Goldman Sachs now sees a series of rate cuts at every FOMC meeting this year, and Citi is calling for 0.5% cuts in both September and December. JPMorgan said there was a strong case for a rate cut even before the Fed’s meeting in September.
Wall Street analysts' main concern: If the Fed waits for data to confirm the economy is weak, it could be too late to head off a recession.
Market Indicators & Recession Predictions
One way for policymakers to be more forward-looking is to assign greater weight to financial market indicators in their analysis. During the postwar period, however, some indicators are more reliable than others in predicting recessions.
Economists, for example, have long viewed equity markets as being unreliable. In a 1966 Newsweek article, Paul Samuelson famously quipped that the stock market had predicted nine of the past five recessions. An update by Steve Liesman of CNBC in 2016 found 13 bear markets in the postwar era and seven recessions within 12 months. When the 2022 bear market is included the track record is only 50%.
The quick turnaround in equity markets this past month is the latest example of how investors can change their views very quickly as new information unfolds.
By comparison, economists recognize bond market indicators have been more reliable in anticipating recessions. Furthermore, an inverted yield curve — in which the yields on longer-dated bonds are below those for shorter-dated instruments — has correctly predicted the last nine U.S. recessions.
Yield Curve Reliability & Other Credit Indicators
In a prior commentary, I suggested that the yield curve's winning streak may be over because the post-COVID-19 cycle is considerably different from previous business cycles. This may explain why a recession has not materialized thus far, even though the yield curve has been inverted since mid-2022. Still, I consider it a useful indicator to monitor the risk of recession.
Another set of useful indicators is credit spreads between corporate bonds and U.S. Treasuries. When the risk of a recession increases, corporate credit spreads — both for investment-grade bonds and high-yield bonds — typically widen significantly. Yet, this is not happening, and corporate credit spreads are well below their long-term averages (see Figure 1 below).
Figure 1. Historical Credit Spreads
Source: Bloomberg.
One explanation is that credit markets have become bifurcated, especially for high-yield bonds. Thus, spreads between BB- and B-rated bonds versus Treasuries are at their tightest deciles in four decades, whereas those for C-rated bonds are near the median. This suggests investors are differentiating between credits that are performing and those that are not.
Pressures are also building in the leveraged loan space, which now rivals the size of the high-yield market at $1.5 trillion in debt outstanding. Fitch Ratings recently revised its leveraged loan default rate estimate for 2024. The range is 5.0% to 5.5%, up from 3.5% to 4.0% previously. This mainly reflects cash flow pressures from slowing gross domestic product growth and high interest rates that, "pose challenges to highly levered issuers' liquidity positions and ability to service debt," Fitch wrote.
Summary
Weighing these considerations, my conclusion is the most reliable indicators do not signal a recession is imminent. Accordingly, the Fed should not take emergency action to bolster the economy.
However, there is evidence that economic activity and employment are softening, and the lowest quality and most highly leveraged segments of credit markets are showing signs of strain. In this context, the Fed is correct that the time has come to ease monetary policy.
The principal unknown is where the federal funds rate will eventually settle.
My take is that with the funds rate at 5.25% to 5.50%, real interest rates are relatively high at about 3%. The bond market currently is pricing in about 2% of rate cuts in the balance of this year and next, according to Bloomberg. This estimate appears reasonable to me, although I suspect the Fed will proceed gradually in the balance of this year.
A version of this article was posted to Forbes.com on September 3, 2024.
