Update: The Tortoise and the Hare – the history of central bank hiking cycles 

In our recent paper The tortoise and the hare ¹, we examined the history of previous central bank hiking cycles including forward looking recessionary indicators. Two of the indicators we examined were based on the shape of the yield curve. At the time of writing, these yield curve based indicators, the 2s10s spread often quoted by the media and a more short-end oriented measure preferred by the Federal Reserve (“Fed”)², were at odds and signalling different outcomes–as a reminder the preferred measure used by the Fed is the Fed Forward Spread which is the 18M3M forward minus the current 3-month US government bond yield. The 2s10s curve had inverted and was flashing a future recession signal, while the Fed’s measure was instead steepening indicating continued growth. These counter directional indicators enabled investors to maintain optimism that the Fed would be able to control inflation in the long run, avoiding a meaningful recession that has historically accompanied rate hiking cycles from high levels of inflation. While equity markets and, to an extent, credit markets continue to discount the Fed achieving the proverbial soft landing, rates markets have begun to shift. In recent months, the Fed’s indicator has turned sharply, having fallen over 200 bps from its peak, and is approaching convergence in sign with the 2s10s indicator, as detailed in Figure 1 below.

As a reminder, the Fed Forward Spread is an indicator of future short-term rates. When the rate is moving upwards it means the Fed will be looking to hike rather than cut rates over the next two years. The opposite is true when the rate is moving lower (and even inverting). Hiking rates is often associated with improving growth and, towards the end of a cycle, an overheating economy, while cutting rates normally accompanies slowing growth or a recession. Stagflation would be the one, and currently potentially relevant, exception where a central bank would likely need to hike or maintain rates, despite a recession.

Whilst the Global Dynamic Asset Allocation (GDAA) committee’s view remains that ultimately the Fed will bring inflation under control without causing a major downturn,  as we detail in our mid-year outlook³, we feel it is important to note that indicators have turned in recent months, in particular the Fed Forward spread. However, while downward momentum has been strong, the Fed Forward spread still remains above its 20-year median–and in positive territory–so the outlook implied by the rates market for a recession has not turned fully bearish yet and is still indicating a weakening growth outlook rather than an outright recession which is in line with our view.

Reiterating our mid-year outlook, we believe no major recession will likely be achieved for the following reasons:

A cool off in commodity prices and inflation beginning to roll over

• Goods inflation, such as second hand cars, have begun to cool from their highs seen earlier in 2022.  Commodity prices have also begun to fall in some sectors, in particular energy and industrial metals. These decreases in prices may help to ease pressure and allow headline inflation to cool further. Note, however, this trend is not universal with European energy markets continuing to face exogenous pressures from the conflict in Ukraine.
  
• However, before the Fed can fully believe that they have controlled inflation, we must witness a decrease in the stickier ‘services’ type inflation, which have not shown any signs of decreasing thus yet.

Private sector balance sheets are strong and can provide a cushion for economic downturns

• Transfer payments issued to consumers in 2020 led to significant excess savings and a strong consumer balance sheet. These excess savings can support consumers and the economy in two ways a) if a downturn does occur excess savings can continue to support output and b) can support consumers if there was an increase in unemployment.

Earnings have remained and are forecasted to remain robust

• 4 out of 5 companies in the US during the most recent earnings season reported meeting or exceeding earnings expectations. Corporates have so far been able to pass through input cost pressures onto the consumer without a taking a hit on profits. Again, the outlook in Europe is not as rosy due to ongoing energy price shock.

^{1 https://insightcommunity.mercer.com/research/6285921faf53d80021af42c6/Mercer_The_tortoise_and_the_hare_A_history_of_central_bank_hiking_cycles}

^{2 The Fed Forward Spread is the 18M3M forward minus the current 3-month US government bond yield. The 2s10s spread is the spread between the current 10-year and 2-year US government bond yield. Both are used to examine the shape of the yield curve and indicators of future recessions. Powell, the chairman of the Fed, has previously noted that this is the Fed’s preferred measure to monitor the yield curve rather than the 2s10s spread. https://www.federalreserve.gov/econres/feds/the-near-term-forward-yield-spread-as-a-leading-indicator-a-less-distorted-mirror.htm}

^{3 https://insightcommunity.mercer.com/research/62dabad8af87fe002177b892/Mercer_2022_mid_year_outlook}