Searching for Certainty in the Fed Pause Cycle
The global capital markets and the geopolitical environment remain extremely fluid and uncertain, but recent decisions by the US Federal Reserve to pause interest rate hikes may provide a clearer view of the near-term economic picture.
The impact of the “pause cycle” and a “buyer’s strike” in the US Treasury market, as well as global politics were key topics in a fireside chat, “The Capital Markets & Geopolitical Crossroads,” between Joe Latini, MUFG Investor Services’ Chief Commercial Officer, and Steve Chiavarone, Senior Vice President, Federated Hermes, during our recent Global Alternatives Summit in Miami.
For much of the past year, Joe noted that strategists within the same financial firms had diametrically opposed views when interpreting economic signals and whether the economy faced a recession.
Steve said that entering a “pause cycle” follows classic economic tradition. “Historically speaking, you can get inflation down if you can get the Federal funds rate at least over the inflation rate or the nominal GDP rate, one of the two” he said. “They’re above the inflation rate, basically at the nominal GDP rate. So, it does make sense for them to pause.”
By stepping away from the debate about potential recessions “and that argument back and forth about soft landing/hard landing, you can actually start to make investment decisions,” he said.
Steve noted that the economy rallied 20 to 25 percent before recessions dating back to 1990, and that the unemployment rate has never risen during a Fed rate hike cycle.
“In fact, the S&P 500 has hit an all-time high each of the last five times that the Fed paused,” Steve said. “Our base-case scenario is that you’re going to grind higher over the course of this year, and you are going to test the old high. That does not preclude a material slow-down next year, and it’s still very much in the probability set. But we don’t think it’s today.”
A unique element of the current economic environment has been “buyer’s strike” in the U.S. Treasury market, Joe said.
Steve agreed, saying that the supply/demand dynamic “is different and profound but [has] uncertain implications.” With the US issuing a “flood of Treasury supply,” the three largest structural Treasury buyers—the US Federal Reserve, the Bank of Japan, and BRICS countries (Brazil, Russia, India, China and South Africa)—have significantly reduced demand.
“What’s happening with the bond market is something we haven’t seen in at least 75 years,” Steve said. For example, in the past, two-year yields might fall faster than 10-year yields and financial conditions would loosen. “This time around, the Fed paused in July and the bond market said, ‘Here comes another 100 basis points of tightening. See what your mortgage market feels like with an 8 percent rate.’ And that’s different. It’s the first time that the yield curve is un-inverted in at least 50 years with financial conditions tightening.”
The “buyer’s strike” concept could have an impact on geopolitics as the US issues debt to fund support of conflicts including the Ukraine-Russia war, Israel’s battle against Hamas, and tensions in the Indo-Pacific region. “One way or another, we’re financing the conflicts,” Steve said. “You need to issue debt in order to do that. In terms of supply of treasuries, supply of debt and pressure on the Federal Government, this represents an upside risk there.” Even with market and geopolitical uncertainty, and the potential for a recession, Steve urged patience for investors. “Even if you are someone who is bearish, and even if you are someone who sees the conditions for a recession, I think we’re still 6, 9, 12 months away from that,” he said. “And the risk is that you could have equity markets move back to all-time highs.”