Fed Predicts Mild Recession in 2023

Minutes from the March FOMC meeting reveal that Fed officials believe a mild recession is likely in 2023. The FOMC predicted 0.4% total GDP growth in 2023 but a 2.2% growth in Q1. The discrepancy indicates that there will be a pullback later in the year to lower the 2.2% growth down to 0.4%. 

The Fed has a very delicate job to do. It believes there is more work to be done on inflation (political speech for more rate hikes), but also must balance the pressure in the banking industry connected to those rate hikes. Vice Chair for Supervision, Michael Barr, said the banking sector is "sound and resilient." Still, staff economists believe the economy will contract. “Given their assessment of the potential economic effects of the recent banking-sector developments, the staff’s projection at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years,” the meeting summary stated.

There are multiple reasons beyond this article to believe that a recession looms on the horizon. Let’s explore three.

Inverted Yield Curve

 An inverted yield curve is a traditional and reasonably accurate indicator of a coming recession. The inverted yield curve has accurately predicted a recession in seven out of the last eleven inversions.

An inverted yield curve means the interest rate is higher for shorter than longer-term bonds. 

Historically, analysts compared the two-year to the ten-year U.S. Treasury securities. If there is a better return on the two-year than the ten-year, recession fears increase. The current (at the time of writing) two-year is 3.96%, and the ten-year is 3.45%. The two-year and ten-year securities have been inverted for several months. The graph comes from the Chicago Fed’s website. The grey areas represent recessions. Dips below the line represent an inverted curve. Most of the time, the recession immediately follows the inversion. Still, a few examples of a time lag from the inversion to recession exist.

Federal Reserve Chairman, Jerome Powell, told the market that the indicator the Fed looks at is the 3-month to the forward 18-month yield curve. The three to eighteen curve is inverted, the worst it has been this century. Most of the market believes that the Fed will cut interest rates later in the year due to the higher cost of borrowing and inversion. However, St. Louis Fed President James Bullard believes that the Fed should stick to raising interest rates as long as the labor market remains strong.

Less than two weeks ago, OPEC+ made a surprise announcement to reduce oil production by 1.16 million barrels per day. In twelve days, the oil price has increased by $6.93 a barrel or 9.16% (at writing time). After the production cut, Goldman Sachs raised its 2023 oil price prediction from $90 to $95, another 15.85% increase from current prices.

Oil prices affect every area of the economy. Higher oil prices translate into higher production and transportation costs for virtually every tangible good or service imaginable. The International Monetary Fund studied oil price shocks’ correlation to inflation from 1970-2015. The study found that a 10% oil price increase translates into a 0.4% inflation increase. The Fed must decide what to do with the statistically probable higher-than-predicted inflation numbers due to the oil price spike. 

The Fed wants multiple consecutive months of consistent market behavior before pivoting. On Wednesday, Richmond Fed President Thomas Barkin said, "I'm waiting for inflation to crack. It's moving in the right direction, but in the absence of a month or two months, or three months with inflation at our target, it's hard to make the case that we're compellingly headed there (a steady inflation rate of 2%).” 

An oil price spike, even an anomaly, will reset the calendar for inflation progress. The strong job numbers and an increase in inflation will probably provoke the Fed to continue raising rates, even though the market expects the opposite. The problem is the banks. Suppose the Fed raises rates to slow inflation. In that case, additional pressure on the regional banks will be added, which can lead to contagion across market sectors.

Since the March 10 collapse of Silicon Valley Bank (SVB), the world has been concerned about a global systemic banking system failure. Signature Bank collapsed two days after SVB. U.S. regional bank stocks tanked. A few days later, Swiss banking giant Credit Suisse was infused with $53 billion and bought by its competitor UBS for a fire sale price of $3 billion about two days later. The FDIC took unprecedented emergency measures to shore up the banking industry.

The run on SVB began when investors realized that SVB would only be able to return about 80-90% of the deposited money. The banks fell into trouble after debt mismanagement and pressures of higher interest rates indicated liquidity issues. Depositors quickly pulled funds from small to mid-sized regional banks and moved to "too big to fail" banks. $120 billion was removed from smaller banks and redeposited into larger banks. Most larger banks exceeded earnings today and boasted that the reason was higher interest rates. (I guess it's technically true but very misleading. The big banks exceeded earnings because they got an influx of $billions with a month left in the quarter. Despite all the fanfare, the banking sector is not strong because the big banks beat earnings on the backs of regional banks crumbling.)

SVB was primarily a venture capital bank for the tech sector. Investors invest heavily in the tech companies driving the S&P 500. There are eleven sectors in the S&P 500. The tech sector is the most significant sector of the S&P 500, representing 26.1%. Higher interest rates will make tech investments more expensive and less profitable. The stress on the banks to maintain liquidity and debt ratios will reduce the number of loans made. When you combine the higher cost of debt and fewer loans being made, you have a recipe for disaster in the tech sector, which can drag the entire stock market down.

The Fed must decide the economy’s poison. Higher interest rates can slow inflation but collapse the banking system. Pausing or pivoting rates can ease some pressures but reset the inflation clock by months. Either way, there is a high probability of economic pain in the paper markets ahead. Instead of waiting for the market downturn later this year, why not rebalance your portfolio into precious metals now?

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