Piloting the landing of the US economy was a complex mission. During the covid crisis, the Fed and the Government filled the plane (economy) with a mix of fuels never before experienced (trillions of fiscal and monetary stimulus combined). The plane gained so much speed in such a short time that it ended up overheating. In the end, the Fed had to pull the handbrake (unprecedented interest rate hikes and stimulus withdrawal), causing a rapid loss of height, which may now end in a crash. In Europe, although the situation is not exactly the same, the risk seems similar, according to experts at JP Morgan.
What happens in the US with the Fed
“The Fed faces a difficult task on Wednesday, it looks like it’s past the point of no return: a soft landing now seems unlikely, with the plane in free fall (lack of market confidence) and engines about to die (bank loans)”, warn economists at JP Morgan.
The sharp rises in interest rates have caused a contraction in the money supply that will have serious repercussions for the economy. The withdrawal of stimulus is drying up credit, while interest rate hikes hit the economy. The damage is already done, now we just have to wait for what happened in the markets to be reflected in the real economy.
JP Morgan analysts explain in their weekly newsletter that this is nothing out of the ordinary: “When the Fed hits the brakes (raises interest rates) there’s always someone who taps the windshield.”
“Over the past few months, the Federal Reserve has been slamming on the brakes hard. Upfront, of course, it’s hard to know which institution, sector, or asset class is in the passenger seat. (If it were obvious, they would have buckled up Lately, however, we have a better idea of who suffered from the Fed’s aggressive tightening: last week, two banks, Silicon Valley Bank and Signature Bank, were placed in FDIC custody.
Credit has been one of the growth engines of the US economy in recent years. If this engine fails, it will be difficult to keep the plane in flight. But what’s worse, the collapse of this engine could infect the rest of the economy’s engines: “A very rough estimate is that slower loan growth by medium-sized banks could subtract between half a percentage point from the level of GDP over the next one or two years”, assures JP Morgan.
“We think this is broadly consistent with our view that tighter monetary policy will push the US into recession later this year. It is not surprising that a campaign to raise interest rates of the Fed causes stress in the financial system; the strange thing would be that he didn’t do it”, sentence these specialists.
the minsky moment
On the other hand, the geopolitical conjuncture allied to the monetary tightening coordinated by most of the most important central banks in the world “increased the possibility of a Minsky moment in the markets and in geopolitics. Even if central bankers manage to contain the contagion, it seems that the conditions Credit markets will tighten faster due to pressure from markets and regulators.
This credit short-circuit has certain positive implications (there is no harm that cannot be good). If funding stops, aggregate demand will cool down and with it inflation. This would help the Fed get the job done and restore price stability. Once this point is reached: inflation is under control and the economy is in recession, the Fed can start cutting interest rates to turn the game around, that is, to return to supporting the economy and seek full employment again. First destruction and then reconstruction.
The BofA experts explain it this way: “Our central thesis has been that, to return to 2% inflation, it would probably be necessary to eliminate imbalances in labor markets in a manner consistent with the downturns of the previous economic cycle. recent events are generally consistent with our forecast. A severe credit crisis could mean a harder landing for the economy and a quicker turn towards rate cuts by the Fed,” writes the Bank of America (BofA) analysts Mark Cabana, Michael Gapen and Alex Cohen in a note to clients. For now, these economists maintain the forecast of a mild recession and a return to 2% inflation by the end of 2024.
Central bankers have started to withdraw stimulus en masse in 2022 as credit clearly starts to slow, has the dreaded Minsky Moment arrived? Maybe so, according to JP Morgan. The event named after the prestigious economist Hyman Minsky It occurs when markets crash after a period of excessive optimism and complacency.
Minsky pointed out that one of the triggers could be an increase in financing costs, which prevents more indebted investors and companies from meeting debt service. Rising US inflation and wages forced the Fed to tighten faster, which, along with the ECB’s monetary tightening, caused bond yields to rise for months. This situation is making debt refinancing more expensive for more leveraged companies and investors.
This ‘moment’ ends when over-indebted agents with problems meeting their financial obligations are forced to sell even their most solid investments to pay off their loans (something similar happened with the SVB in the US, it had to sell its bonds to face the withdrawal of deposits ), which forces agents to recognize latent losses, generating turbulence in all markets and a huge demand for liquidity which forces central banks to show their ability as lenders of last resort.
“The rising cost of borrowing and reduced access to credit increase the chances that the economy will suffer a hard landing. Interest rate cuts, which we have been anticipating for a long time, are likely to be the key issue in the second half of 2023,” they point out.ING analystsled by James Knightley, in a commentary.
The Fed’s Play
“If the Fed raises rates by 25 basis points this Wednesday, we could have one last 25 basis point hike before summer, leaving the Fed funds range at 5-5.25%. , given the likely damage to the flow of credit, in addition to the long and varied delays of monetary policy changes in the economy, in what was the most aggressive tightening cycle of the last 40 years”, they add.
“The chain of bank failures has put the Fed in an extremely difficult position, with even more precision needed to achieve the legendary soft landing. Now it looks much more like a hard landing,” he says. Genevieve Roch-Decter of Grit Capital. The financial analyst sees three recession bells ringing in the market right now: rates, bank failures and corporate profits.
The first of these warnings comes, for Roch-Decter, from a fixed income market that has been experiencing its craziest days since 2008. The measure of fear in the fixed income market, the ICE MOVE Index of Implied Volatility, reached levels never seen in 2008 . Actual yield movements reached levels seen during the Black Monday stock crash of 1987 and the vagaries of the Volcker era of 1982, when record rate hikes triggered a recession and brought inflation under control. “The question now is whether the real economy is heading towards the same type of slowdown that followed the global financial crisis”, emphasizes the expert.
The seen bank failure, he continues, will reverberate throughout the economy: “Regional banks provided a large amount of essential loans for the growth of prosperous companies. in borrowing will hurt every business. As the banking sector deteriorates, the economy deteriorates.”
Finally, regarding business results, Roch-Decter explains: “Let’s not forget: we continue to have a slowing economy, and companies remain mired in a massive slowdown in growth and declining profits. While the multiples have been squashed due to rapidly increasing weights, we still have the other piece of the puzzle to solve: the fundamentals. Now everyone is hiding in defensive sectors as cyclicals are much more exposed to contractionary economic conditions.”
“Through its soft landing narrative and its maintenance of overly flexible monetary policy, the Fed has trapped itself in an end game of financial dominance. The US central bank is withdrawing liquidity (through tightening its monetary policy) and providing liquidity to the system (by bailing out troubled banks), which echoes the Bank of England’s disagreement last autumn to respond to the pension fund liquidity crisis,” said Kevin Thozet, member of the Carmignac manager’s research committee.
However, Thozet concludes: “In a context where the Federal Reserve is willing to maintain tight financial conditions, with the job market and inflation uncomfortably resilient, the volatility associated with this conundrum is not entirely bad news. will lead to even tighter credit conditions (businesses have hoarded manpower, now banks will hoard cash) and therefore weigh on demand (which plays a bit in the Fed’s favour)”.
An ECB mistake?
On the other hand, “the rescue of several American banks did not manage to completely calm the markets, which swept away another large bank in Europe”, maintain the economists of the American bank.
These experts make a comparison between the current moment and what happened in 2011 in Europe, when the European Central Bank, then commanded by Jean-Claude Trichetraised interest rates triggering a panic in sovereign debt that was about to be the beginning of the end of the euro: “At a time similar to that of Trichet, the ECB raised interest rates by 50 basis points.”
Last week, the ECB announced a new rate hike (50 basis points) to control inflation, which remains at 8.5% year-on-year. The movement seemed justified by price resistance, however, some experts expected some easing in the face of strong financial turmoil.
A financial crisis has more than much potential to do the ‘dirty work’ for the ECB with inflation. However, European bankers opted to keep the pace of tightening at 50 basis points, taking key interest rates to levels not seen since 2008.
Analysts at JP Morgan believe that this measure could be a mistake, too tight for an economy headed for recession. However, controversy is the dominant note in the analysis of the ECB’s move, since the central bank’s mandate is clear in this sense: to stabilize inflation at 2% in the medium term. This mandate is different from that of the Fed, which has a dual mission: price stability and maintaining full employment.