Hard Landing Panic Has Markets Rethinking Central Bank Bets

Central banks have succeeded. In engineering a recession scare.

Rate hike bets were trimmed again on Friday, at the end of a week that found bond yields retreating from this year’s highs as concerns about the economic impact of rapid rate hikes proliferate.

Around 182bps of Fed hikes were priced by year-end as of Friday morning. That was a bit lower versus the prior session, but it’s worth noting that at the height of Thursday’s rally at the US front-end, markets priced just 175bps from Jerome Powell, suggesting the Fed would deliver a well telegraphed encore of the largest hike since 1994 at next month’s meeting, followed by 50bps in September and 25bps at this year’s two remaining meetings. Or 75bps in July followed by consecutive 50bps moves and then a December pause. Eurodollars were pricing 50bps in Fed cuts in 2023.

It’s been all hikes of late (figure one the left, below).

And when it comes to Fed tightening cycles, it never ends well (figure on the right, above). “Every Fed hiking cycle in the fiat high-debt era has led to some kind of financial crisis somewhere across the world,” Deutsche Bank remarked, in a recent slide deck.

“Fed funds futures are suggesting a max policy rate for this cycle of 3.55% versus the Fed’s own projection of 3.75%,” BMO’s Ian Lyngen and Ben Jeffery wrote on Friday, adding that while “it’s tempting to offer a shrug and a glib ‘what’s a quarter point between friends?’ the more relevant aspect is that investors are now undershooting what the Committee is signaling will be delivered.”

That, Lyngen and Jeffery emphasized, is “a meaningful shift in the market’s perception [and] warrants further attention if for no other reason than the divergence is a marginal vote of confidence for the lower rates thesis and offers context for how two-year yields can trade at just 3% despite the Fed’s guidance that overnight rates will be 75bps higher in less than a year.”

Two-year yields were on track for their largest weekly decline since the onset of the pandemic (figure below).

The rally came on the heels of a dramatic selloff triggered by the May CPI report and subsequent repricing ahead of the June FOMC meeting.

In Congressional testimony this week, Powell tacitly conceded that the odds of a benign overall outcome from the Fed’s efforts to bring down inflation by bludgeoning demand with a blunt object have diminished. On Thursday, during a second day of testimony, he employed the word “unconditional” to describe the Fed’s commitment to the inflation fight, a term that featured in the Fed’s semi-annual report to lawmakers. In short: The probability of a hard landing is now likely much higher than it was had rate hikes commenced last year.

Markets recognize that sobering reality and it’s finding expression in rates. Traders have long expected a steeper, but ultimately truncated hiking cycle, a reflection of the Fed’s front-loaded tightening. Now, though, markets are inclined to pricing a rate path that’s both shallow and short. Terminal rate pricing has come in materially — by around 50bps from the highs at ~4%, with rates seen peaking in March, versus mid-2023.

These dynamics can become self-fulfilling. The optics could prompt market participants to add hedges against a downturn, which would only reinforce perceptions about the likelihood of a recession, and thereby doubts about the Fed’s capacity to push rates too far into restrictive territory.

In Europe, where German two-year yields dropped the most since 2008 Thursday amid recession fears, the market was priced for 147bps in hikes from the ECB by December. That number was more than 190bps just 10 days ago. The same dynamic is evidenced in BoE pricing. Terminal rate expectations were below 3% for March of 2023 on Friday morning.

This is unfolding as commodities and consumer sentiment roll over. It may sound strange today, but it’s entirely possible that by this time next year, central banks will be discussing (if not delivering) rate cuts against a backdrop of weaker corporate profits and struggling economies, set against lower raw materials costs and 12-month inflation prints lapping a high base.