By Avi Deutsch
May 11, 2023 – Two games of chicken are unfolding in the U.S. economy, the one between investors and the Federal Reserve, and the other between Democrats and Republicans in Washington D.C.
Despite the Fed’s recent interest rate hike last week, bond investors continue to expect that the Fed will cut rates several times before the end of the year. This view stands in sharp contrast to the Fed’s expectations about the future path of interest rates.
True, the Fed has signaled that this could be the last consecutive interest rate hike in this cycle. This decision is influenced by slowing inflation, reinforced by the figures released on Wednesday showing that inflation slowed to 4.9% in April. But another important contributor to a possible pause in interest rate hikes is the evident fragility of the banking system. The Fed knows that weakness in the banking system is likely to slow the U.S. economy, but when and how much remains an open question.
Still, a pause in interest rate hikes is far from a promise that interest rates are coming down. The slowdown in inflation is certainly positive, but the absolute inflation rate remains stubbornly high at more than double the Fed’s target of 2%. Add to this the tight labor market, with unemployment figures released last Friday showing that unemployment dropped from 3.6% to 3.4%, and rate cuts seem unlikely without a sharp economic slowdown.
If bond investors seem convinced that a recession is imminent, public equity investors appear more sanguine about the future. The S&P 500 has remained resilient despite a third quarter in a row of declining earnings and is now trading at an 18X multiple of future earnings, above its 20-year average. The Nasdaq Composite, especially sensitive to future interest rates, is up 20% from its 2022 lows. These levels leave very little margin of safety should the Fed need to raise rates again because of sticky inflation or cut them sharply because of a bad recession.
As if the future path of the U.S. economy is not uncertain enough, a political standstill over the debt ceiling could make matters a lot worse. A default of the U.S. government and the fallout from halting social security, Medicare, and other government payments would cause immense damage to the fragile economy. Despite early unilateral actions on both sides, the only way to avoid a disastrous outcome is for the two sides to work together. Let’s hope our politicians avoid driving the U.S. economy off a cliff. If they don’t, it could prove bond investors to be right.
Wishing you a happy start to the summer!
— AMD
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