Markets dropped again in the second quarter of 2022 as investors continued digesting the new paradigm of high inflation and a more aggressive Federal Reserve. This was especially true for stocks, which saw their declines from the first quarter accelerate into the second quarter. Bonds also declined, but at a slower pace from the previous quarter.
In an effort to bring down inflation, which sits stubbornly at a 40-year high, the Fed raised rates by a quarter of a point in March, half a point in May, and three-quarters of a point in each of the last two meetings in June and July. Yet even with a historically large series of interest rate increases, the Fed Funds Rate – the rate banks pay to borrow money – remains well below the rate of inflation. Given the recent Fed statements about raising rates as much as necessary to bring inflation back down to the 2% range, some economists think that interest rates may have to go much higher to ultimately get inflation back to a more desirable level.
The bond market disagrees. At their current values, bonds have just a handful of additional interest rate increases priced into the market (between 1 and 3, depending on how fast the Fed raises them). In fact, longer-term rates are actually dropping, meaning that bond traders believe that the Fed will be successful in choking off not only inflation, but likely the economy too, and will have to start reducing interest rates again in the 2-10 year range. Those declining longer-term rates have resulted in an inverted yield curve, where short-term interest rates are higher than longer rates. An inverted yield curve is a very strong recessionary signal, with a recession nearly always following such conditions.
Some would say we are already in a recession. The dictionary definition of recession is “a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters”, and the second quarter just posted that second successive decline. In reality though, GDP is just one of several factors used by the National Bureau of Economic Research (NBER) to determine when a recession has occurred. Other data points, including Gross Domestic Income, Household Employment, Industrial Production, and Personal Consumption Expenditures, have not declined. In fact, GDP may be the only factor the NBER follows that is showing a decline, at least for now.
Meanwhile, the stock market is taking the declining GDP in stride, having risen every day since it was announced. Traders may be betting that if we are already well into a recession then we could be coming out the other side of it in the coming year, especially if it is a mild recession, as many economists expect. However, with industrial production and consumer spending remaining high and unemployment low, it is hard to imagine we are truly in a recession now, which means a real recession may yet be coming, with economic conditions deteriorating, as they historically do.
So while recession is not a foregone conclusion, assuming we are not already in one, the risk is certainly rising. And even if we end up in an actual recession, it remains to be seen how deep the decline will go and how long it might last. Many economists think that a recession occurring in this environment would be shallow and short-lived. Of course economists do not have a great track record when it comes to accurately forecasting recessions, so take that with a grain of salt. As Yogi Berra said, “It's tough to make predictions, especially about the future.”
The information above represents the opinion of financial advisor Travis Rus, and is not necessarily that of RJFS or Raymond James. It is not a complete summary of all available data necessary for making an investment decision and does not constitute a recommendation, nor is it a complete description of the securities, markets, or developments referred to herein. Opinions are subject to change without notice. Information has been obtained from sources considered reliable, but we cannot guarantee that it is accurate or complete. Past performance does not guarantee future results. Investing involves risk and you may incur a profit or loss.
Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise.
