The prediction of recession is gaining momentum

Outlook: Today brings the Dallas Fed survey and a slew of speeches by Fed officials, but the big story will be the November nonfarm payrolls on Friday, currently forecast at a lesser 200,000 from 261,000 in October (but the unemployment rate the same 3.7%). At the same time, the prediction of recession is gaining momentum, according to the 2/10 yield inversion, now at a high -0.74 points. Today the Fed speakers are NY Fed Williams and St. Louis Fed Bullard, with chief Powell on Wednesday.  

The Fed has been herding the market into seeing a 50 bp hike at the next meeting on Dec 12-13. Assuming this week’s comments from Feds, especially Powell, continue in the same vein, we are going to hear the same blather as before–the Fed is newly dovish, or even the Fed will now pause hiking altogether. How quickly we forget! Various Fed officials have rebutted both points and will do so again, but not before markets enjoy some drama.  

The press is bewitched by unrest in China, with students piggybacking on Covid shutdowns to protest the lack of free speech. Some continue to imagine China will relax anti-Covid measures but we have no hard information to back up that view. To a greater extent than anyone wants to admit, the outlook for the US and global economy does depend on China and its policy choices.  

For some reason no one can identify, we have a risk-off mode from events in China but without the dollar benefiting. To be fair, yesterday the euro fell quite hard, from 1.0408 on Friday to 1.0339 yesterday, but then quickly reversed into a rally that hit 1.0497 so far today. It’s unusual for risk aversion to be coupled to a falling dollar and we should probably consider the anomaly to be short-lived.   

Last week we wrote about the amazing Krugman article showing that if the true cost of housing is used to calculate inflation, the peak has indeed been reached and the true, actual rate is already trending to around 3-4%. Were the Fed to see things that way, too, the ending rate for Fed funds can be 5-5.25% and leave room for a real return, which is at the heart of the Taylor rule. Any rate of return that is zero or negative in real terms flies in the face of 5,000 years of interest rate history.  

Ah, but there’s a problem with this single-asset explanation. The supply chain may be nearly fully fixed, but other categories of goods and services will likely still see price rises. This will be due in part to rising wages, which are nowhere close to catching up to price rises in things like food, and also the inflation mentality becoming entrenched.  

We expect inflation to dip a bit but land around 4% and stay there. This is also the view of El-Erian, who writes in the FT today that whatever happens with respect to the coming recession, it’s a mistake to buy into “short-lived and shallow” narrative. Granted, there is some decent evidence of that outcome, but “they are not deterministic. What is true for the economy as a whole is far from true for the whole population. The most vulnerable people and companies have already run down their savings, face more limited income opportunities and have less access to low-cost credit. Their detrimental impact on growth is not easily offset by the better off.  

While inflation will come down in the next few months, we are likely to see rate stickiness at about 4 per cent…. [but equally important], The Fed is dealing with a trilemma also involving financial stability.  

“While fiscal policy will not take a sharp turn to austerity in an absolute sense, it will be contractionary on a relative basis. Finance will be similarly affected – banks’ lending caution is likely to be amplified by liquidity compression and greater risk aversion among non-banks.  

“Then there is the global angle. The US is not the only important economy facing slowing growth. Europe is already in a recession and China remains hampered by its zero-Covid policy. Then there is Japan’s challenging exit from yield curve control. All this at a time when growth models need a major revamp.  

“Such simultaneous growth contractions open the door to vicious feedback loops, accentuating the need for greater humility when predicting what lies ahead. So do behavioural considerations. When taken out of our comfort zone by troubling news, our biases often kick in to make the news less unsettling. Last year’s version of this for consensus forecasters boiled down to “yes, we have high inflation but, don’t worry, it is transitory”. This year’s version is “yes, we face a recession but don’t worry, it will be short and shallow”.  

Both analytical and behavioural factors suggest that we should be cautious about the “short and shallow” consensus call. Companies, governments, households and equity investors should plan with an eye to a range of possible outcomes, with no single one dominating as a baseline. Such fluidity calls for safeguarding as much as possible against policy errors, corporate missteps and market accidents.  

“Scenario planning for a wider range of possible outcomes is hard work and takes time, and much of it will eventually prove redundant. Betting on a shaky consensus forecast, however, could prove much more damaging.”  

This point of view is unsettling because we prefer to make up a story and stick to it until someone or something forces us to change the tune. It seems that right now the market is in gloomster mode, expecting the worst, something stock markets do not like. We doubt it will affect what Powell says on Wednesday, but you never know. If it’s that 50 bp that is holding the dollar down when it “should” be rising, it’s doubtful Powell would want to change that. The pullback is not in danger yet.  

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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