Recession risk will limit how far Fed can go

The threat of a considerable slowdown or even a recession in the US will put a cap on how far the Federal Reserve can raise rates. We expect that the Federal Funds rate will end 2022 at 2% following a 50bps hike at the May FOMC meeting and 25bps over subsequent meetings up to November but the outlook for persistent hikes in 2023 is much more clouded. We have two more 25bps hikes pencilled in for H1 2023 which brings our expectation for the terminal rate to 2.5%, lower than the Fed’s median projection of 2.75%.

A critical timespread in the US yield curve, the gap between 2yr and 10yr US Treasuries, briefly inverted overnight, crossing over at around 2.39%. The immediate catalyst for the inversion appeared to be a brief rally in USTs spurred by signs of a de-escalation in the war in Ukraine with yields on both near- and long-dated dropping. Another part of the yield curve, the 5s10s spread, had already inverted last week to as low as -7bps. Yield curve inversions have normally preceded recessions in the US by around 6-12 months.

The last time the 2s10s spread inverted was in Q3 2019 when markets responded to negative developments in the US-China trade war prompted by tariffs imposed by the Trump administration and Chinese authorities. A recession followed roughly half a year later though it was caused by the Covid-19 pandemic rather than underlying weakness in the US or global economy.

In the current context, the risk of a considerable slowdown in the performance of both the US and other major economies appears high. Growth was already set to slow in 2022 compared with the post-pandemic boost experienced in 2021 while central banks, particularly the Federal Reserve, are moving to much more hawkish stances to handle inflation. Now with the war in Ukraine further threatening global supply chains and pushing commodity inflation even higher, the threat of stagflation—low or no growth and high prices—appears acute. At the same time the pandemic has shown that it still poses a risk with China having to impose lockdowns on major centres of its economy. Conditions for a US recession appear relatively ripe while the hope of sustained rapid levels of growth in China’s economy now looks antiquated.

Beyond acting as an upward barrier on how far the Fed can raise rates in its fight against inflation, the prospect of a recession will act as a constraint on the upward move in market yields as well. We expect yields on the 10yr yield to peak at around 2.6% in Q3-Q4 this year before starting to fade back on signs of an imminent drop back in activity in the US economy and much lower global growth. Commodities too, the crucible of the immediate high inflation narrative, would also be at risk of falling back should growth decelerate sharply, particularly in China.

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