Market Perspective – Fed conundrum and financial stress support continued defensive tactical posture

What happened

Markets have been under pressure on the combination of the Federal Reserve (Fed) raising rates and renewed stress in the financial sector. PacWest fell more than 40% as it considers a possible sale, and First Horizon’s stock also declined sharply after a merger deal with TD Bank was mutually terminated.

Our take

It is unusual to see the Fed raise rates during a period of stress in the banking system. But the scar tissue left behind by the elevated inflation of the past few years has created a conundrum for the Fed. That is, with inflation well above target levels, the Fed is hesitant to cut rates and risk that inflation does not come down towards its 2% goal. The tradeoff is a degree of short-term economic pain.

What’s also unusual is the 2-year U.S. Treasury yield, a proxy for where the market believes short-term rates will be in the future, is more than 1% below the Fed funds rate. This is the market saying it ultimately believes the Fed will be pressured to cut rates.

This 1% threshold was first breached in March for only the sixth time since 1989. In all prior cases, the Fed cut rates during that same month or the next. Instead, this time, the Fed raised rates in part due to core inflation that is still running above 5% versus an average of 2.8% during the five prior periods. This point illustrates the Fed’s conundrum.

Notably, recessions occurred sometime over the next year following all other times the 1% threshold was breached except 1998. This is consistent with our House View of elevated recession risks later this year as the lagged impact of rates filter into the economy. Moreover, lending and credit conditions, the lifeblood of the economy, are only expected to become tighter, especially given recent bank pressures.

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