Stuck Between A Rock And A Hard Place

Scott Anderson
Chief Economist
Bank of the West

The Fed, and by extension the financial markets, are being squeezed into a tighter and tighter corner, trapped between intolerably high inflation and a rapidly slowing U.S. economy that is increasingly looking pre-recessionary. Stock and bond markets have been volatile, whipsawed between lingering inflation fears and growing recession fears. But in recent days, the fixed income markets have been increasingly focused on the recession risks. Ten year Treasury bond yields plunged to 2.76% today down from a high of 3.25% on June 28th. The Treasury yield curve has become more inverted with the closely watched 2-10 spread inverting by about 20 basis points over the last eight trading days. Historically, inversion of the 2-10 Treasury spread has been a good leading indicator of recession.

Inverted 2-10 Spread Signals Rising Recession Risks
A big driver of the drop in the 10-year Treasury yield over the past month has been a significant drop in the bond market’s future inflation expectations as a hawkish Fed, slowing demand, and rising recession risk conspire to push inflation out of the bond market’s calculus.

1-Yr Inflation Breakeven Drops More Than 100 Bps
The Fed will welcome these declines in the bond market’s inflation expectations, but will want to see it backed up by a similar decline in consumer inflation expectations. The preliminary July Consumer Sentiment inflation expectations index showed some encouraging movement in that direction, but the Fed will want to see more follow through in the months ahead before they even think about pausing their fight against inflation.

In short, the Fed will not be deterred from raising the Fed funds target rate another 75 basis points next week, and following that up with another 50 basis point move in September, and likely finishing the year with another two quarter-point rate hikes in November and December. The Fed’s job #1 is to bring actual inflation back under control.

On that front, the Fed has continued to lose ground despite 150 basis points of rate hikes since March. The June inflation data revealed an unwelcome and unexpected acceleration in inflation from a level that was already much higher than the Fed can tolerate. This forced us, and likely the Fed, to push up their inflation forecast over the near-term. The FOMC doesn’t have the luxury to respond to slowing demand and rising recession risks yet, when its inflation mandate to maintain stable prices remains so off course.

Inflation Is Too Hot For The Fed To Hold Back
Yet, the steady drumbeat of U.S. economic data continues to deteriorate at an alarming pace. Just this morning, we received a preliminary reading of the S&P Global U.S. Composite PMI (a measure that includes both services and manufacturing businesses) that fell into contraction territory of 47.5 for the first time since May 2020. The plunge in the service PMI to 47.0 in July from 52.7 in June was much worse than expected, given consumer’s pent-up demand for services had been so strong earlier this summer. These are ominous clouds forming over the U.S. economic growth outlook, especially as this follows another big 0.8% decline in the Conference Board’s Leading Economic Indicator (LEI) index for June. The LEI index has declined over five of the past six months.

Composite PMI Falls Into Contraction In July
Until this economic weakness shows up much more prominently in the U.S. employment and unemployment data or inflation data, the FOMC’s tightening path will remain on auto-pilot. It feels a bit like one of those bad horror movies where the creepy music is already playing, but the character continues to walk into the seemingly abandoned house. You know this isn’t going to end well though you’re not yet sure what is about to happen.

To learn more, check out this week's U.S. Outlook Report.

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