David Rosenberg: Brace yourself, the Fed is signalling that a three-quarter recession will start in two weeks

·6 min read

Stocks whipsawed in the aftermath of the United States Federal Reserve’s decision on March 22 to raise interest rates, but ultimately succumbed to selling pressure. Beyond the fact that the Fed was willing to move ahead with tightening in the face of elevated financial risks, the stock market was also hit by comments by U.S. Treasury Secretary Janet Yellen, who said the government isn’t considering “blanket” deposit insurance to stabilize the banking system.

Against this backdrop, we think the risk/reward profile for the broader market is unfavourable. Our preference is to focus on low-volatility stocks, companies with strong balance sheets and limited earnings cyclicality, which are themes we believe will serve investors well in the current environment.

Elsewhere, just like the reaction in the German money market to the European Central Bank’s rate hike last week, the two-year U.S. Treasury yield plunged 23 basis points, even with the 25-basis-point hike from Jerome Powell. The two-year T-note closed the day at 3.94 per cent — light years away from the five-per-cent-plus “terminal” funds rate the Fed has penned in.

The futures market barely moved and predicted the Fed will start cutting in July and finish the year at four to 4.25 per cent, and then drop down to 2.75 to three per cent by the end of 2024. There is one official on the Federal Open Market Committee who has a “dot plot” not far off from where we are — 4.75 to five per cent by the end of this year and then to 3.25 to 3.5 per cent by the end of 2024.

Calling the Fed’s bluff

The FX market seems to be calling the Fed’s bluff that we are going to be seeing more rate hikes, with the DXY dollar index slipping 0.7 per cent and riding the longest losing streak (five days) since April 2021 (gold loved this, rallying 1.7 per cent to US$1,978 per ounce). Oh, and as for the futures strip, it is a toss-up for whether the Fed goes again at the May meeting.

Seeing as the central bank is wholly data dependent, something tells me the data isn’t going to be supportive of the Fed hawks from now until then (and beyond).

One thing that was very interesting is the 0.4-per-cent growth forecast in real gross domestic product for 2023 (on a Q4/Q4 basis), and I say that because the Federal Reserve Bank of Atlanta GDPNow forecast is for 3.2 per cent annualized growth in Q1 (front-loaded by the weather in January). Stringing out what this means for the balance of the year is a steady diet of minus 0.5-per-cent GDP prints (sequential) for Q2, Q3 and Q4.

So, even as Powell suggested this banking sector situation won’t spin out of control, the Fed is implicitly calling for a three-quarter recession starting two weeks from now. And we know the S&P 500 never ever bottoms when the recession is just getting started. Looking over the valley means seeing the whites of the eyes of the economic recovery, which will be a 2024 story best saved to be priced in by the fourth quarter of this year and not earlier. Keep your friends close, your enemies closer and your powder dry.

As Powell kept on talking at the press conference on March 22, the stock market kept going down, but not really because of him since he emphasized that all deposits in the banking system were “safe.” It’s just that at the very same time, Yellen was speaking and said there was no move afoot to provide “blanket” insurance — “not something we are considering” — while also hinting at a warning for bond holders (some of whom got burnt in the UBS Group AG-Credit Suisse Group AG deal). Duelling messages.

This resulted in a five-per-cent drubbing for the KBW Nasdaq bank index, with all 21 members closing in the red. PacWest Bancorp, a California-based lender that has come under pressure alongside other regional banks, said on March 22 that it had tapped emergency cash after a 20-per-cent run on its deposits since the start of the year (sending its stock price down 17 per cent for the day).

Next chapter in bank crisis

The next chapter in the story will shift from concerns over deposits to assets on regional bank balance sheets, notably office real estate, as we have been saying for some time.

And it wasn’t just the duelling messages between Powell and Yellen, but a bad case of cognitive dissonance by the Fed chair himself. He said that rate cuts this year are not the Fed’s “base case.” Yet a year ago, he said that if his preferred yield curve, the so-called “near-term forward spread” (three-month T-bill yields minus the rate 18 months out) turned negative, “that means the Fed’s going to cut, which means the economy is weak.” He added, “In this case, if you’re in a situation where the markets are pricing in significant declines in inflation, that’s going to affect the forward curve.”

Well, guess what? That curve is now inverted to the tune of 134 basis points, an inversion that just took out the prior record negative spread that foreshadowed the 2001 recession. Remember that recession? The “mild” one that touched off a minus 50-per-cent, two-year bear market in the S&P 500?

In his own words, Powell’s preferred curve is saying the economy is going to weaken, inflation is going to sharply recede and the Fed will be cutting rates, and yet his comments yesterday seemed to indicate the economy will emerge in fine shape, inflation will remain troublesome and he has no intention of cutting rates this year. Quick, fetch this guy a shrink.

What is clear to me is that Powell is downplaying the risks in the financial system, which is more fragile than he realizes. Yes, yes, we all know this is not 2008/09 all over again, and perhaps the recent bank failures were outliers. But many banks have unrealized bond losses on their books and many also have a heavy dependence on uninsured deposits and acute concentration of commercial real estate and commercial and industrial loans on their balance sheets.

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.


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