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Economists are often called dismal scientists, as they are more likely to see the proverbial glass as half empty than half full. That label is vividly on display now, as the forecast of a recession within the economic community is more pronounced than ever. In its May survey, the consensus of Blue-Chip economists place a 61 percent odds of a recession this year, and even the Federal Reserve's staff of economists expects a downturn in the second half. These gloomy forecasts are echoed in the financial markets, where investors are pricing in a high probability of a downturn before the end of the year. Simply put, if a recession is coming, it would be one of the most advertised on record.
While the banking panic that rocked the financial markets in March has been defused, its aftereffects are rippling through the economy. We will have a better sense of how much credit conditions have tightened on May 8 when the Federal Reserve releases its Senior Loan Officer Opinion Survey. The good news is that lending standards may not have tightened as much as originally feared. The bad news is that standards started to tighten before the panic emerged, so even a smaller narrowing of the credit spigot would amplify the downside risks facing the economy. As it is, recession odds have been building for some time, thanks to the Federal Reserve's aggressive rate-hiking campaign over the past year. With credit conditions set to tighten further, those odds are now even higher; indeed, the financial markets fully expect a recession to begin sometime over the second half of this year.
No one would argue that the Fed's rate-hiking cycle is nearing an end, but that terminal date is looking more elusive with each data point. A pause in the cycle at the June meeting is still the mostly likely bet; but rather than a bridge to cuts, it is looking more like a skip before the Fed hikes again in July or at a subsequent policy meeting. Even traders are pulling back on the rate-cut bets, pricing in smaller reductions over the second half of the year than expected a few weeks ago. Indeed, as of Friday, the financial market had priced in less than a 50 percent probability the Fed would lower rates by the end of the year.
With the clock ticking on the debt-ceiling saga, hopes are rising that negotiations will generate a last-minute compromise that avoids a default. More than anything, that prospect, until talks broke off late Friday, lifted market spirits this week, giving stock prices a sturdy boost and sending Treasury yields higher, with most maturities ending the period up 20-25 basis points from last Friday. Importantly, market-based odds of a Federal Reserve rate hike at the mid-June policy meeting also rose to about 40 percent from 10 percent a week ago. That said, the markets still believe that what goes up, must come down; hence, futures traders continue to price in rate cuts before the end of the year, albeit they did move back the timing and pare the size of reductions compared to expectations of a few weeks ago.
The Federal Reserve drew comfort from positive news on the inflation front this week, taking some of the sting out of the previous week's relatively strong jobs report. There's still another jobs and consumer price report due out before the next FOMC meeting that concludes on June 14, which could sway the Fed's decision whether to raise rates again or hit the pause button. Following the benign consumer price report on Wednesday, the market-based probability of a pause increased to almost 85 percent, according to the CME probability tool. We caution, however, that market sentiment can be highly fickle, and trader perceptions could turn on the dime if incoming data favors a different decision.
As expected, the Federal Reserve lifted its benchmark federal funds rate by another quarter-percentage point to the 5-5.75 percent range, the tenth hike in the most aggressive tightening campaign since the early 1980s. While the outcome was expected, the meeting was hardly a snooze-fest, as it created more suspense over what comes next than seen following any of the previous nine gatherings. Whereas the previous confabs left little doubt that another rate hike was imminent, this one left open a range of possibilities – and a firestorm of speculation that will undoubtedly remain front and center for weeks to come. If there was one clear message that most commentators agree on, it is that the consecutive string of increases may have ended, as Fed officials signaled that a pause is likely at the June meeting.
The House Republicans finally submitted a bill that would raise the debt ceiling, ushering in round one in what shapes up to be a protracted fight, as the Senate Democrats are sure to duck the opening salvo. So far, the financial markets appear unfazed by the prospect of an ugly battle poised to go down to the final round, estimated to be early summer. Quite possibly, the combatants will not settle the score until a major market incident sends a scare into the proceedings. Aside from a spike in Treasury bill yields on issues scheduled to mature around the drop-dead date, there is more of a "what, me, worry?" sentiment among investors than a "woe is me" attitude. Stocks added to their hefty year-to-date gains this week, continuing to rally on Thursday and Friday after House Speaker McCarthy submitted his debt-ceiling proposal.
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