Investors expressed concern just a few months ago that the Federal Reserve was not combating inflation strongly. After several significant rate increases, some increasingly worry that the Fed’s monetary policy adjustment may cause the economy to enter a recession.
Interest rate futures were putting in a 20% possibility that the Fed will increase rates by 100 basis points at its meeting on September 21 as the markets were still recovering from last week’s shockingly high inflation reading. When the market was arguing whether the rise would be 50 or 75 basis points earlier this month, that number was practically unimaginable. With the terminal rate for U.S. fed funds currently at 4.4%, investors are also pricing in more substantial rate increases in the future.
While some shareholders had derided the Fed earlier in the year for advancing too slowly, several are now concerned that the rapid rate rises may make it difficult for legislators to measure the consequences of monetary toughening on the economy, raising the probability that they will raise rates quite far.
“We’re all scared of over-tightening and the hard landing scenario, because the Fed has over-tightened and caused hard landings more often than they have not.”Jeffrey Sherman, deputy chief investment officer at bond fund DoubleLine
Considering the 225 basis points of tightening that the Fed has indeed implemented, figures from the United States suggest that the economy appears to be chugging ahead. The World Bank has warned that even a “modest knock” might cause the global economy to enter a downturn, and FedEx has reported a severe earnings shortfall that it has attributed on sluggish growth.
Jeffrey Gundlach, the CEO of DoubleLine, expressed concern over a potential rate hike to CNBC last week after criticizing the Fed for proceeding too slowly in June. The largest hedge fund in the world’s history, Bridgewater Associates, was founded by Ray Dalio. He recently stated on LinkedIn that a rise in interest rates to 4.5% might cause a 20% decline in stock prices. The key policy rate set by the Fed is 2.25 to 2.5%.
“There is rising risk that the Fed … will overshoot with rate hikes in response to stubbornly high inflation data. By doing so, they increase the risk of a recession rather than the soft landing that they are seeking to achieve.”Steven Oh, Global Head of Credit and Fixed Income, Co-Head of Leveraged Finance at PineBridge Investments
A 19% loss in the S&P 500 this year has already been attributed to concerns about the Fed tightening. A significant selloff in Treasury bonds contributed to the strong decrease in global treasuries.
Price pressure, according to Fed Chairman Jerome Powell, may be reduced without a significant downturn in the economy. But he has also made clear that the central bank will fight against inflation with tenacity.
“Central banks are facing much sharper tradeoffs. They need to choose to either live with more inflation or they kill growth. There’s nothing in between.”Jean Boivin, Head of the BlackRock Investment Institute
Given that BlackRock anticipates the Fed to increase rates to 4.50% or higher next year, Boivin remains underweight-developed market equities and does not believe government treasuries to be alluring.
“Overtightening would come with material economic pain … risk and liquidity stress.”Daniela Mardarovici, co-head of multi-sector fixed income at Macquarie Asset Management
Given how persistent the inflation has been, senior international economist at Vanguard Andrew Patterson thinks it could be best for the Fed to choose the option of strong action. However, the company predicts a 65% risk of a recession in the following 24 months.
According to some analysts, the economy might be sufficient to withstand a more assertive Fed. Employment in the US, a key indicator of the health of the economy, increased more quickly than anticipated in August.
“The probability of a soft landing has definitely gone down, but the probability of a hard landing has also probably come down a little bit” given the signs of continued demand in the economy.Steve Bartolini, portfolio manager for the T Rowe Price US Core Bond Strategy
The reversal of different portions of the Treasury bond market, a phenomenon that has previously foreshadowed recessions, is one of the most alarming market signals. John Taylor, the founder of foreign currency trading and CEO of Taylor Global Vision, is one of the investors who believe there will be more suffering in the months to come.
DoubleLine’s Sherman hopes the Fed will respond to evidence of a slowing economy instead of pushing through with rate increases despite of the repercussions.
“This idea of flexibility, data dependency, we all want to hear that. We don’t want to hear automatic pilot.”Jeffrey Sherman, deputy chief investment officer at bond fund DoubleLine