We’re in the midst of seeing a repeat of 2022 where stocks and bonds decline together as interest rates rise and the Fed confirms its intention to keep conditions tighter for longer. The problem is that now we’ve got some fairly strong signals that the economy might not hold up nearly as well this time around. Outside of the GDP readings still looking healthy, we’re seeing corporate bankruptcy filings already ahead of full-year 2021 and 2022 levels. Commercial credit availability is actually contracting for the first time since coming out of the financial crisis. Home affordability is at record lows. That’s not even mentioning the fact that higher interest rates have made consumer credit levels nearly unsustainable. Corporations will soon need to roll trillions of dollars of existing debt over at significantly higher rates in the next 12-24 months and that will likely drive the number of bankruptcies even higher. The Fed was late to arrive in addressing skyrocketing inflation and they’ll likely be late in balancing out monetary conditions. The Fed generally has a preference to overdo it and adjust later instead of underdo it and miss the mark. This will likely be the case again in 2023/2024 and recession risk will only continue rising in Q4.
We got a better than expected JOLTS report earlier this week, which undoubtedly supports the notion that the labor market is still healthy and will offset any immediate economic concerns with respect to growth or the consumer. The main event, of course, will be Friday’s non-farm payroll report, which is expected to show another addition of around 200K jobs in September. Monthly job growth has slowed, but not nearly to the levels that might warrant a market response. Probably not until we see the monthly number turn negative will investors start to react and potentially price in an imminent recession. Right now, there’s about a 50/50 chance of a rate hike before year-end. If we get another beat on non-farm payrolls, it could result in the markets more forcefully pricing in another hike and another extension of “higher for longer”. If that does happen, it’s probably another leg lower for stocks & bonds and another leg higher for the dollar.
Right now, the Treasury yield curve looks like it’s positioned to steepen further heading into Q4. Both the 10Y/3M and 10Y/2Y Treasury yield spreads are now less than half as negative as they were during their peak with the latter moving to just -0.35%, the smallest it’s been since October of last year. This is noteworthy because 1) it’s usually short end yields that shrink in steepenings, but instead it’s long end yields expanding and 2) the yield curve uninverting usually happens just prior to recessions. Given that this steepening is an anomaly (long yields expanding), there’s little precedent for assessing the timing of a potential recession. The Fed usually sees the signs and begins cutting the Fed Funds rate ahead of a technical recession start date, but rate cuts are nowhere on the radar right now due to high inflation. I really think it raises the risk that something breaks and risk asset prices decline violently.
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