Market sentiment is largely optimistic after the recent 50 basis point cut in the benchmark fed funds rate target range, to 4.75% to 5.00% from 5.25% to 5.50%. But it’s too soon to view this as a return to an easy money policy. Rather, I see this move as the Federal Reserve merely easing off the brakes on its restrictive monetary policy. This is not necessarily the start of a growth phase, as the target range remains significantly higher than the neutral rate of 2% to 3%.
Real GDP Vs. Effective Federal Funds Rate
Source: Federal Reserve Bank of St. Louis
The chart above shows the correlation between the fed funds rate and the U.S. GDP growth rate. History has shown that when restrictive Fed policies coincide with the transition from an inverted to a normalized yield curve, recessions follow.
Here are three red flags that make me concerned we may be headed in the same direction.
Quantitative Tightening
Quantitative tightening is the Fed’s approach to reducing its balance sheet by allowing Treasury and mortgage-backed securities to mature without reinvestment. This strategy aims to drain excess liquidity from the market and curb inflation, helping to restore more balanced financial conditions. By not reinvesting, the Fed increases Treasury bond yields—which, in turn, raises borrowing costs, restricts lending, hampers business expansion and weakens corporate earnings, ultimately slowing down the economy.
As inflation continues to decline from its 9.1% peak in June 2022 to 2.5% in August 2024, it appears unlikely that the Federal Reserve will fully ease off its tightening measures, especially as it starts to regain control over inflation. In his statement following the Fed’s recent rate cut, Chair Jerome Powell highlighted concerns about potential future inflation, saying, “We’re trying to achieve a situation where we restore price stability without the kind of painful increase in unemployment that has come sometimes with this inflation.”
The Federal Open Market Committee reinforced this cautious optimism, noting that it is more confident inflation “is moving sustainably toward 2%, and judges that the risks to achieving its employment and inflation goals are roughly in balance.” This balanced approach reflects the Fed’s careful strategy: Rather than shifting to a growth mindset, the goal is to achieve a soft landing by stabilizing prices while minimizing any adverse impact on the labor market.
The Fed balance sheet, which peaked at $9 trillion in spring 2022, decreased to $7.1 trillion by August 2024. Initially, the Fed allowed $95 billion in Treasuries and mortgage-backed securities to roll off each month, but this pace has since slowed to $60 billion. Again, the Fed is easing back after aggressive tightening in 2022 and 2023 but remains cautious about fully shifting gears.
U.S. Federal Reserve System, Total Assets
Source: Federal Reserve Bank of St. Louis
Yield Curves
According to the Federal Reserve Bank of New York, eight yield curve inversions have occurred since 1969. And in all eight cases, there was a recession within 18 months of the inversion and within six months of the normalization. In July 2022, the 2-year Treasury and the 10-year Treasury inverted and were followed by a technical recession in Q1-Q2 2022. As of this writing, the yield curve has normalized again, reflecting the Federal Reserve’s decision to cut interest rates in response to delicate economic conditions.
Twice, both quantitative tightening and an inverted-to-normalized yield curve occurred simultaneously: the Global Financial Crisis and the COVID-19-triggered recession. Now, no two recessions are the same, and the primary drivers for those previous recessions are not present in today’s economy. A normalized yield curve typically signals a stable economic environment. But the current economy’s underlying vulnerabilities—coupled with the recent yield curve inversion to normalization driven by the interest rate cut—raise concerns about a potential recession. The consistency of this historical relationship between yield curve behavior and recessions prompts the question: Will history repeat itself?
10-Year Vs. 2-Year U.S. Treasuries
Source: ustreasuryyieldcurve.com
Corporate Earnings and the Slowing Job Market
Corporate earnings continue to fall short compared to U.S. GDP growth and inflation, highlighting a growing disconnect between corporate profitability and broader economic performance. While the definition of healthy earnings varies across industries, they are typically considered strong when they outpace both GDP growth and inflation. Corporate profits grew had strong 9.8% growth in 2022 but declined sharply since, dropping to 1.5% in 2023 and -1.4% in Q1 2024. Preliminary estimates suggest a modest rebound of 1.7% in Q2 2024.
Meanwhile, inflation eased to 2.5% in August 2024. GDP growth has been relatively stable, with annualized growth of 2.5% in 2023 and 2.8% in Q1 2024, reflecting steady but cautious economic expansion. This divergence suggests that while the broader economy is holding, companies face increasing pressure to maintain profitability.
Job openings have continued to decline, from 8.8 million in August 2023 to 7.7 million in July 2024, while unemployment has been ticking up over the same period. Additionally, job creation has ranged from stagnant to declining. In March, 310,000 non-farm jobs were created; in April, 108,000; in May, 216,000; in June, 118,000; in July, 89,000; in August, 142,000. In February 2023, Powell said job growth of from 100,000 to 150,000 jobs per month is necessary to maintain current employment levels without reducing the unemployment rate. Over the past six months, job growth has only exceeded this threshold once.
Conservative Optimism
In times of economic uncertainty, we remain optimistic about the performance of credit investments for the foreseeable future, because they remain protected within the capital stack and are providing yields that are on average higher than they have been in the past decade.
The recent Fed rate cut has sparked optimism. But ongoing quantitative tightening, yield curve dynamics, lagging corporate earnings and potential labor market weaknesses paint a picture of an economy more fragile than it appears on the surface. The Fed’s conservative policies continue to act as an anchor, limiting the potential for a resurgence of inflation at the cost of restricting economic growth. As these factors evolve, it will be important to monitor their impact on overall economic health and the potential for a recession in the coming months.
Subscribe
Subscribe to receive the latest articles about fund updates, industry news and market trends.
