News in Charts: All aboard – Fed jumps on ‘soft landing’ train

The FOMC increased its benchmark interest rate by 25 basis points after its July meeting, as had been widely anticipated. There was no surprise, either, in the accompanying statement, which differed little from June’s. However, there was a change of tone in the press conference that followed. In response to a question, Jay Powell said that the Fed staff are no longer forecasting a recession. Market participants have increasingly priced in this type of ‘soft landing’ scenario. Despite still-high inflation, risk assets have done very well this year alongside expectations for relatively steep interest rate cuts next year. Such an outcome is certainly plausible. But it has become increasingly priced in by investors and policymakers, leaving the door open for disappointment.

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Mr Powell also made clear that a further increase in September was possible, on top of July’s 25-basis-point rise. There will be a lot of data to digest by the next time the FOMC meets, including two inflation reports and two jobs reports. The median forecast in June’s ‘dot plot’ was for the federal funds rate to finish the year at 5.6%. With ongoing signs of resilience in the economy, investors have almost caught up with that view, pricing in an additional 2023 rate hike since the last meeting. This evolving outlook has led to some reassessment of the speed of travel next year. Market pricing now implies 125 basis points in rate cuts from December 2023 to December 2024, compared to 150 basis points in expected cuts at the time of the June meeting.

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Bond market pricing remains consistent with continued disinflationary pressures, despite fading recession expectations. US economic data have been surprising to the upside, as the world’s largest economy continues to show impressive resilience. Meanwhile, risk appetite among investors continues to remain high. As of July 26, the S&P 500 had posted a 20% increase this year, with the equivalent Nasdaq figure double that. Those gains have been aided by expectations for a rebound in profits next year. The average estimate among Refinitiv contributors is consistent with a 10% increase in earnings per share in 2024 after a forecast 3% drop this year. With interest rate hikes still working their way through the system, inflation slowing and margins historically high, that seems to be a remarkably benign backdrop.

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It is natural to respond to the incoming data, and the US economy now looks stronger than many forecasters, including ourselves, anticipated. However, there is also a risk of extrapolating recent trends into the future. A tension exists between strong demand and sustained disinflation: the former makes the latter less likely, yet market pricing seems to be consistent with a positive outcome for both the real economy and inflation. Such an outcome is indeed possible, but it is increasingly fully priced in. As we laid out in our Global Outlook, Summer 2023,[1] we see recession risks from the ‘long and variable lags’ of monetary policy rising by the end of the year and peaking in the middle of 2024. It can be hard to resist a risk-on mood in markets. Momentum is often self-fulfilling. However, it cannot continue indefinitely. As summer draws to a close, we anticipate greater headwinds to the ‘soft landing’ narrative, with an accompanying downward skew to the outlook for risk assets.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

[1] Charts and analysis from Fathom’s Global Outlook, Summer 2023 are available to Refinitiv subscribers in Chartbook.

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