No Signs of Imminent Recession: Why Bond Investors Should Approach Insurance Rate Cuts with Caution

Summary:

• No signs of an upcoming recession: The macroeconomic backdrop, characterized by a cooling labor market, resilient consumer spending, and persistent inflation, does not align with the notion of aggressive interest rate cuts. Recent data, including strong retail sales, challenge the expectation of significant rate cuts by year-end.
• The Federal Reserve might be preparing to cut rates in September: Recent speeches by FOMC members, including Bostic, Bowman, Daly, and Powell, suggest that a rate cut may be on the table for September.
• Rate cuts may not lower long-term yields: An insurance rate cut by the Fed may not lead to lower long-term yields, as the long-term equilibrium Fed Funds rate could continue to rise. This creates a "floor" for the long end of the yield curve, meaning that long-term yields might not decline as expected, and could even rise, especially if markets demand a higher risk premium for holding long-term bonds.
• Caution in bond market duration: Given the potential for economic acceleration and the rising long-term equilibrium Fed Funds rate, it's crucial for investors to be selective with bond maturities.

No imminent recession, but a Fed insurance rate cut may still be on the horizon: implications for bond markets

Recent U.S. economic data and insights from FOMC members suggest that we may be heading toward an "insurance" Fed rate cut in September, even as the economy remains fundamentally strong. An "insurance" rate cut occurs when the Federal Reserve lowers interest rates preemptively—not in response to a recession, but as a safeguard against potential economic slowdowns or emerging risks. The goal is to "insure" the economy, promoting borrowing, investment, and spending to maintain growth and guide the economy toward a soft landing.

While such a move could be favorable for stock markets, the impact on bond markets may be more complex. Typically, falling inflation combined with interest rate cuts boosts sovereign bond prices. However, this time, investors may need to be more selective about which maturities they choose, as there is a risk of economic acceleration that could affect long-term yields (to learn more about it click here).

One key consideration is the long-term equilibrium Fed Funds rate, which could rise even as the Fed cuts rates in the short term. This would create a "floor" for the long end of the yield curve, meaning longer-term bond yields might not fall as much as some investors expect. The reason for a potential increase in the long-term Fed Funds rate is the current strength of the economy, which may be operating at a higher equilibrium level than in the past.

The long-term neutral Fed Funds rate remained stable at 2.5% from June 2019 until March of this year, when it began to rise, currently standing at 2.75%. If the Fed were to lower rates to 2.75% in the coming years, the 10-year U.S. Treasury yield would likely stabilize at around 100-150 basis point premium over the Fed Funds rate as the yield curve normalizes. This would imply a fair value for the 10-year Treasury between 3.75% and 4.25%. If the neutral rate continues to increase, the fair value for the 10-year Treasury would rise accordingly.

This scenario suggests that while the front end of the yield curve, driven by monetary policy expectations, may shift lower, the long end could rise sharply, leading to the much-feared bear steepening of the yield curve. Bear steepening occurs when long-term bond yields climb faster than short-term yields, causing the curve to steepen. In this case, I would anticipate short-term yields to drop as the Fed cuts rates, while long-term yields increase as markets demand a higher risk premium for holding longer-term bonds. This shift is typically viewed unfavorably by markets, as a significant portion of the economy’s debt is tied to long-term interest rates.

The macroeconomic backdrop suggests that an imminent recession is unlikely.

After more than a week of market expectations leaning heavily towards an impending recession, U.S. economic data released on Thursday challenged that narrative. U.S. retail sales excluding food rose by 2.6% over the past year, while continuing claims surprised on the downside over the last two weeks, indicating that consumers continue to spend and the job market remains resilient, despite the uptick in the July unemployment rate.

What can we say about the current state of the economy?

• Consumers continue to spend. The latest retail sales report shows growth in ten out of thirteen categories, with declines only in clothing, miscellaneous store retailers, and sporting and hobby goods. This trend is supported by the University of Michigan Consumer Sentiment Survey, which has recorded rising consumer confidence since June 2022. While there are indicators of economic uncertainty—such as more selective spending habits noted in Walmart’s recent earnings report and a cooling of post-pandemic travel—it’s clear that a recession is not around the corner.
• Inflation remains a significant concern, with the NFIB survey this week indicating it as the top issue for 26% of small businesses. A notable 24% of these businesses plan to increase prices in the next three months, signaling continued inflationary pressures. The St. Louis Fed’s Price Pressures Measure suggests a 97% probability that inflation will exceed 2.5% over the next year.
• Despite rising unemployment, a recession seems unlikely. The current unemployment rate of 4.3% is slightly higher than recent historical lows but remains below the long-term average of 5%. The increase is primarily among reentrants and those on temporary layoffs, rather than permanent job losers. This stability in permanent job loss suggests the labor market is resilient. Additionally, wages are growing at 3.6%, above the historical average, further supporting consumer spending and economic stability.

Given these conditions, the expectation of substantial interest rate cuts (up to 100bps) by year-end appears overly optimistic. Persistent inflation and robust economic activity suggest that the Federal Reserve may not be able to deliver the expected rate cuts. As a result, markets have adjusted their expectations, reducing the likelihood of a 40 basis point rate cut in September to 33 basis points and lowering the probability of four rate cuts by the end of the year.