Tag: Stock markets

The Fed is likely to hike rates by a quarter point but it must also reassure it can contain a banking crisis

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The Federal Reserve is expected to raise interest rates Wednesday by a quarter point, but it also faces the tough task of reassuring markets it can stem a worse banking crisis.

Economists mostly expect the Fed will increase its fed funds target rate range to 4.75% to 5% on Wednesday afternoon, though some expect the central bank could pause its hiking due to concerns about the banking system. Futures markets were pricing in a roughly 80% chance for a rate rise, as of Tuesday morning.

The central bank is contemplating using its interest rate tools at the same time it is trying to soothe markets and stop further bank runs. The fear is that rising rates could put further pressure on banking institutions and crimp lending further, hurting small businesses and other borrowers.

“The broader macro data shows some further tightening is warranted,” said Michael Gapen, chief U.S. economist at Bank of America. He said the Fed will have to explain its double-barreled policy. “You have to show you can walk and chew gum at the same time, using your lender-of-last-resort powers to quell any fears about deposit flights at medium-sized banks.”

U.S. Federal Reserve Chair Jerome Powell addresses reporters after the Fed raised its target interest rate by a quarter of a percentage point, during a news conference at the Federal Reserve Building in Washington, February 1, 2023.

Jonathan Ernst | Reuters

Federal regulators stepped in to guarantee deposits at the failed Silicon Valley Bank and Signature Bank, and they provided more favorable loans to banks for a period of up to one year. The Fed joined with other global central banks Sunday to enhance liquidity through the standing dollar swap system, after UBS agreed to buy the embattled Credit Suisse.

Investors will be looking for assurances from Fed Chairman Jerome Powell that the central bank can contain the banking problems.

“We want to know it’s really about a few idiosyncratic institutions and not a more pervasive problem with respect to the regional bank model,” said Gapen. “In these moments, the market needs to know you feel you understand the problem and that you’re willing and capable of doing something about it. … I think they are exceptionally good at understanding where the pressure is that’s driving it and how to respond.”

A month of turmoil

Markets have been whipsawed in the last month, first by a hawkish-sounding Fed and then by fears of contagion in the banking system.

Fed officials begin their two-day meeting Tuesday. The event kicks off just two weeks after Powell warned a congressional committee that the Fed may have to hike rates even more than expected because of its battle with inflation.

Those comments sent interest rates soaring. A few days later, the sudden collapse of Silicon Valley Bank stunned markets, sending bond yields dramatically lower. Bond yields move opposite price. Expectations for Fed rate hikes also moved dramatically: What was expected to be a half-point hike two weeks ago is now up for debate at a quarter point or even zero.

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The 2-year Treasury yield is most sensitive to Fed policy.

Messaging is the key

Gapen expects Powell to explain that the Fed is fighting inflation through its rate hikes but then also assure markets that the central bank can use other tools to preserve financial stability.

“Things going forward will be done on a meeting-by-meeting basis. It will be data dependent,” Gapen said. “We’ll have to see how the economy evolves. … We’ll have to see how financial markets behave, how the economy responds.”

The Fed is scheduled to release its rate decision along with its new economic projections at 2 p.m. ET Wednesday. Powell will speak at 2:30 p.m. ET.

The issue is they can change their forecast up to Tuesday, but how does anyone know?

Diane Swonk

Chief economist at KPMG

Gapen expects the Fed’s forecasts could show it expects a higher terminal rate, or end point for rate hikes, than it did in December. He said it could rise to about a level of 5.4% for 2023, from an earlier projection of 5.1%.

Jimmy Chang, chief investment officer at Rockefeller Global Family Office, said he expects the Fed to raise interest rates by a quarter point to instill confidence, but then signal it is finished with rate hikes.

“I wouldn’t be surprised if we get a rally because historically whenever the Fed stops hiking, going to that pause mode, the initial knee-jerk reaction from the stock market is a rally,” he said.

He said the Fed will not likely say it is going to pause, but its messaging could be interpreted that way.

“Now, at the minimum, they want to maintain this air of stability or of confidence,” Chang said. “I don’t think they’ll do anything that could potentially roil the market. … Depending on their [projections], I think the market will think this is the final hike.”

Fed guidance could be up in the air

Diane Swonk, chief economist at KPMG, said she expects the Fed is likely to pause its rate hiking because of economic uncertainty, and the fact that the contraction in bank lending will be equivalent to a tightening of Fed policy.

She also does not expect any guidance on future hikes for now, and Powell could stress the Fed is watching developments and the economic data.

“I don’t think he can commit. I think he has to keep all options on the table and say we’ll do whatever is necessary to promote price stability and financial stability,” Swonk said. “We do have some sticky inflation. There are signs the economy is weakening.”

Fed needs to 'call a timeout' and stop hiking rates, says Bleakley's Peter Boockvar

She also expects it will be difficult for the Fed to present its quarterly economic forecasts, because the problems facing the banks have created so much uncertainty. As it did during the Covid pandemic in March 2020, the Fed might temporarily suspend projections, Swonk said.

“I think it’s an important thing to take into account that this is shifting the forecast in unknown ways. You don’t want to overpromise one way or the other,” she said. Swonk also expects the Fed to withhold its so-called dot plot, the chart on which it shows anonymous forecasts from Fed officials on the path for interest rates.

“The issue is they can change their forecast up to Tuesday, but how does anyone know? You want the Fed to look unified. You don’t want dissent,” said Swonk. “Literally, these dot plots could be changing by the day. Two weeks ago, we had a Fed chairman ready to go 50 basis points.”

The impact of tighter financial conditions

The tightening of financial conditions alone could have the clout of a 1.5 percentage point hike in rates by the Fed, and that could result in the central bank cutting rates later this year, depending on the economy, Swonk said. The futures market is currently forecasting much more aggressive rate cutting than economists are, with a full percentage point — or four quarter-point cuts — for this year alone.

“If they hike and say they will pause, the market might actually be okay with that. If they do nothing, maybe the market gets nervous that after two weeks of uncertainty the Fed’s backing off their inflation fight,” said Peter Boockvar, chief investment officer at Bleakley Financial Group. “Either way we still have a bumpy road ahead of us.”

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The Fed could also make a surprise move by stopping the runoff of securities from its balance sheet. As Treasurys and mortgages mature, the Fed no longer replaces them as it did during and after the pandemic to provide liquidity to financial markets. Gapen said changing the balance sheet runoff would be unexpected. During January and February, he said about $160 billion rolled off the balance sheet.

But the balance sheet recently increased again.

“The balance sheet went up by about $300 billion, but I think the good news there is most of that went to institutions that are already known,” he said.

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A recession could come sooner on cooling bank lending

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Plummeting bond yields, steep drops in oil and stock prices, and a sharp jump in volatility are all signaling that investors fear a recession is now on the near horizon.

Stocks were down Wednesday, as worries about Credit Suisse spooked markets already concerned about U.S. regional banks following the shutdown of Silicon Valley Bank and Signature Bank. 

“What you’re really seeing is a significant tightening of financial conditions. What the markets are saying is this increases risks of a recession and rightfully so,” said Jim Caron, head of macro strategy for global fixed income at Morgan Stanley Investment Management. “Equities are down. Bond yields are down. I think another question is: it looks like we’re pricing in three rate cuts, does that happen? You can’t rule it out.”

Bond yields came off their lows and stocks recovered some ground in afternoon trading, following reports that Swiss authorities were discussing options to stabilize Credit Suisse.

Wall Street has been debating whether the economy is heading into a recession for months, and many economists expected it to occur in the second half of this year.

But the rapid moves in markets after the regional bank failures in the U.S. has some strategists now expecting a contraction in the economy to come sooner. Economists are also ratcheting down their growth forecasts on the assumption there will be a pullback in bank lending.

“A very rough estimate is that slower loan growth by mid-size banks could subtract a half to a full percentage-point off the level of GDP over the next year or two,” wrote JPMorgan economists Wednesday. “We believe this is broadly consistent with our view that tighter monetary policy will push the US into recession later this year.”

Bank stocks again helped lead the stock market’s decline after a one-day snap back Tuesday. First Republic, for instance was down 21% and PacWest was down nearly 13%. But energy was the worst performing sector, down 5.4% as oil prices plunged more than 5%. West Texas Intermediate futures settled at $67.61 per barrel, the lowest level since December 2021. 

At the same time, the Cboe Volatility Index, known as the VIX, rocketed to a high of 29.91 Wednesday before closing at 26.10, up 10%.

The S&P 500 closed down 0.7% at 3,891 after falling to a low of 3,838.

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“Bear market bottoms are usually retested to ensure that the low is truly in. The rising risk of recession is now being exacerbated by the increased likelihood that banks will limit their lending,” noted Sam Stovall, chief market strategist at CFRA. “As a result, the outstanding question is whether the October 12 low will hold. If it doesn’t, we see 3,200 on the S&P 500 being another likely target, based on historical precedent and technical considerations.”

Treasury bonds, usually a more staid market, also traded dramatically. The 2-year Treasury yield was at 3.93% in afternoon trading, after it took a wild swing lower to 3.72%, well off its 4.22% close Tuesday. The 2-year most closely reflects investors’ views of where Fed policy is going.

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“I think people are rightfully on edge. I guess when I look at the whole thing together, there’s a component of the rally in the [Treasury] market that is flight-to-quality. There’s also a component of this that says we’re going to tighten credit,” said Caron. “We’re going to see tighter lending standards, whether it’s in the U.S. for small- and mid-sized banks. Even the larger banks are going to tighten lending standards more.”

The Federal Reserve has been trying to slow down the economy and the strong labor market in order to fight inflation. The consumer price index rose 6% in February, a still hot number.

But the spiral of news on banks has made investors more worried that a credit contraction will pull the economy down, and further Fed interest rate hikes would only hasten that.

For that reason, fed funds futures were also trading wildly Wednesday, though the market was still pricing about a 50% chance for a quarter point hike from the Fed next Wednesday. The market was also pricing in multiple rate cuts for this year.

“Long term, I think markets are doing the right kind of thing pricing out the Fed, but I don’t know if they’re going to cut 100 basis points either,” said John Briggs, global head of economics and markets strategy at NatWest Markets. Briggs said he does not anticipate a rate hike next week. A basis point equals 0.01 of a percentage point.

“Credit is the oil of the machine, even if the near-term shock was alleviated, and we weren’t worried about financial institutions more broadly, risk aversion is going to set in and remove credit from the economy,” he said.

Briggs said the response from a bank lending slowdown could be deflationary or at least a disinflationary shock. “Most small businesses are banked by community regional banks, and after this, even if your bank is fine, are you going to be more or less likely to offer credit to that new dry cleaner?” he said. “You’re going to be less likely.”

CFRA strategists said the Fed’s next move is not clear. “The recent downticks in the CPI and PPI readings, as well as the retrenchment of last month’s retail sales, added confidence that the Fed will soften its rigid tightening stance. But nothing is clear or certain,” wrote Stovall. “The March 22 FOMC statement and press conference is just a week away, but it will probably feel like an eternity. Waiting for tomorrow’s ECB statement and response to the emerging bank crisis in Europe also adds to uncertainty and volatility.”

The European Central Bank meets Thursday, and it had been expected to raise its benchmark rate by a half percent, but strategists say that seems less likely.

JPMorgan economists still expect a quarter-point rate hike from the Fed next Wednesday and another in May.

“We look for a quarter-point hike. A pause now would send the wrong signal about the seriousness of the Fed’s inflation resolve,” the JPMorgan economists wrote. “Relatedly, it would also send the wrong signal about ‘financial dominance,’ which is the idea that the central bank is hesitant to tighten, or quick to ease, because of concerns about financial stability.”

Moody’s Analytics chief economist Mark Zandi, however, said he expects the Fed to hold off on a rate hike next week, and the central bank could signal the hiking cycle is done for now.

He has not been expecting a recession, and he thinks there could still be a soft landing.

“I don’t think people should underestimate the impact of those lower rates. Mortgages will go lower and that should be a lift to the housing market,” he said. Zandi said he does not expect the Fed to turn around and cut rates, however, since its fight with inflation is not over.

“I’m a little confused by the markets saying there’s a 50/50 chance of a rate hike next week, and then they’re going to take out the rate hikes. We have to see how this plays out over the next few days,” he said.

Zandi expects first-quarter growth of 1% to 2%. “But the next couple of quarters could be zero to 1%, and we may even get a negative quarter, depending on timing,” he said.

Goldman Sachs economists Wednesday also lowered their 2023 economic growth forecast, reducing it by 0.3 percentage points to 1.2%. They also pointed to the pullback in lending from small- and medium-sized banks and turmoil in the broader financial system.

Correction: This story was corrected to accurately reflect Jim Caron’s remarks that markets are pricing in three rate cuts.

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Fed expected to slow rate hiking to a quarter point but will stay unrelenting in inflation battle

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The Federal Reserve is expected to raise interest rates by just a quarter point but also likely signal it will stay vigilant in its fight against inflation even as it reduces the size of the hikes.

The Fed releases its latest rate decision Wednesday at 2 p.m. ET, and Fed Chair Jerome Powell briefs the media at 2:30 p.m. The expected quarter-point hike follows a half percentage point increase in December, and would be the smallest increase in the federal funds target rate range since the first hike of the cycle last March.

While the meeting is expected to be relatively uneventful, strategists say it could be a challenge for the Fed chief to temper the reaction in financial markets. The markets have been rising as investors expect the central bank might succeed in a soft landing for the economy while also snuffing out inflation sufficiently to move back to easing policy.

“How is he going to tell people to calm down, chill out and don’t get so excited by us getting close to the end of the interest rate increases?” said Peter Boockvar, chief investment officer at Bleakley Financial Group. “He’s going to do that by still saying the Fed’s going to stay tight for a while. Just because he’s done doesn’t mean it’s a quick bridge to an ease.”

Federal Reserve Board Chairman Jerome Powell holds a news conference following the announcement that the Federal Reserve raised interest rates by half a percentage point, at the Federal Reserve Building in Washington, U.S., December 14, 2022. 

Evelyn Hockstein | Reuters

The Fed’s rate hike Wednesday would be the eighth since last March. It would put the fed funds target rate range at 4.50% to 4.75%. That is just a half percentage point away from the Fed’s estimated end point, or terminal rate range of 5% to 5.25%.

“I think he will push back on financial conditions. I think the markets are expecting that. I think people realize how much credit spreads have moved, how much the equity market has moved, how much tech stocks have moved. This month has been extraordinary,” said Rick Rieder, BlackRock’s chief investment officer for global fixed income.

A rally that could dampen the Fed’s efforts

Easy credit and a stock market that is rising too quickly could defeat the Fed’s efforts to chill the economy and crush inflation.

Stocks rallied Tuesday as the Fed began its two-day meeting, capping January’s gain of nearly 6.2% for the S&P 500. The tech sector was up 9.2% for the month. Rates have fallen since the end of the year, with the benchmark 10-year Treasury yield at roughly 3.5%, after it ended December at about 3.9%.

Rieder expects Powell to deliver his comments with a hawkish tone. “I think if he’s hawkish, I think the markets have built that in. I think if he’s not, the market could make another leg,” he said.

In the futures market, fed funds futures continued to price a terminal rate of less than 5%. The futures also show investors expect the Fed to actually reverse policy and cut rates by at least 25 basis points by the end of 2023. A basis point equals 0.01 of a percentage point.

“I think he’s going to be hawkish relative to market pricing,” said Jim Caron, head of macro strategies for global fixed income at Morgan Stanley Investment Management.

Caron said the Fed’s downsizing of its rate hikes will be seen dovish in itself. Prior to December’s 50 basis point hike, the central bank raised rates by 75 basis points four times in a row.

“He wants to defend the validity of the 5% to 5.25% terminal rate [forecast],” said Caron. “At the same time, he sees record housing prices are coming down. Wage inflation is coming down. The auto sector is not doing great. Retail’s not doing so great. The jobs market is doing OK. Wage inflation is coming down but it’s still above comfort levels.”

Listening carefully to the Fed’s messaging

Caron said Powell also wants to be careful not to sound too hawkish. “It’s very easy for there to be a mistake in the communication from the Fed or there could be a mistake in the way the market initially interprets things as well,” he said. “That tells me there’s going to be a lot of volatility.”

Investors will be attuned to any comments Powell makes about the economy and whether he expects it to dip into recession, as many economists forecast. The central bank has not projected a recession in its forecast, but it expects very sluggish flat growth, and it sees the unemployment rate rising sharply to 4.6% later this year, from its December level of 3.5%.

The Fed is not expected to make any major changes in its policy statement when it announces the rate hike. Its last statement said that “ongoing increases” in the target rate range will be appropriate in order to reach a policy position that can send inflation back to 2%.

The Fed is making headway against inflation. Personal consumption expenditure core inflation rose by 0.3% in December and was at 4.4% on an annual basis from 4.7% in November, the slowest increase since October 2021

Strategists say the Fed needs more data and will likely wait until at least March to signal how long it could continue to raise interest rates. If it stays at the same pace, there could be two more quarter-point hikes.

The Fed will not be releasing any new forecasts or economic projections Wednesday. Its next forecast is the quarterly release of economic projections at the March meeting, and that is one way markets will get more clues on the intended rate path.

“They don’t want financial conditions to ease all that much, and they don’t have a new set of forecasts to give, so I think what that means is you have fewer changes in the statement and that line about ‘ongoing increases’ is going to stay the same,” said Michael Gapen, Bank of America’s chief U.S. economist.

Gapen said it will be difficult for Powell to sound too hawkish. “Actions speak louder than words. If they decelerate [the size of rate hikes] for the second straight meeting in a row, it’s hard to back that up with overtly hawkish language,” he said.

Boockvar said Powell should emphasize how the Fed will keep rates at higher levels, despite the market view that it will soon cut rates. “Powell is more focused on inflation going down and staying down than trying to help the S&P 500,” said Boockvar. “His legacy is not going to be determined by where credit spreads are or where the S&P is going. It’s going to be determined by whether he slayed inflation and it stayed down.”

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Inflation is expected to have declined in December, but it may not be enough to stop the Fed

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A woman shops in a supermarket as rising inflation affects consumer prices in Los Angeles, California, June 13, 2022.

Lucy Nicholson | Reuters

The pace of consumer inflation is expected to have fallen slightly in December from the prior month because of a sharp drop in gasoline and energy prices, but the annual rate is still likely to remain uncomfortably high.

According to Dow Jones, economists now expect a decline of 0.1% in the consumer price index on a monthly basis, but inflation is still expected to climb at a 6.5% rate from the prior year. That compares to a gain of 0.1% in November, and a 7.1% pace year over year. However, the CPI is well off the 9.1% peak rate in June.

Core CPI, excluding energy and food, is expected to be up 0.3% in December, gaining 5.7% on a year-over-year basis. Core CPI rose 0.2% in November and 6% on a yearly basis.

“We welcome it with open arms. It’s good news,” said KPMG chief economist Diane Swonk of the expected decline. “It’s great and it helped to fuel consumer spending in the fourth quarter. … But it’s still not enough.”

The consumer price index is expected Thursday at 8:30 a.m. ET. It is the final CPI report before the Federal Reserve’s Feb. 1 interest rate decision. For that reason, the inflation number has become a major event for financial markets, and now some traders are betting it will show inflation slowing even more than economists forecast. They also point to weaker-than-expected wage growth in December’s jobs report, as well as other data that reflects lower inflation expectations.

Stocks rallied on Wednesday ahead of the report. “The market is looking at it as glass half full. Inflation is rolling over, and the Fed is almost done raising interest rates,” said Peter Boockvar, chief investment officer at Bleakley Financial Group. “I think they remember the last two months when you had numbers that were well below expectations. They’re just assuming that’s going to be the case again.”

Expected impact on the Fed

In the futures market, traders continued to bet the central bank will raise rates by just a quarter point at its next meeting. Meanwhile, some economists continue to expect policymakers will increase the fed funds target rate by a half percentage point. Market expectations are just 20% for a 50 basis point hike. A basis point equals 0.01 of a percentage point.

“It’s amazing how much reaction and overreaction there is for one single data point,” said Simona Mocuta, chief economist at State Street Global Advisors. “Clearly the CPI is very important. In this particular case, it does have fairly direct policy implications, which are about the size of the next Fed rate hike.”

Mocuta said a cooler CPI should influence the Fed. “The market has not priced the full 50. I think the market is right in this case,” she said. “The Fed can still contradict the market, but what the market is pricing is the right decision.”

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Wilmington Trust chief economist Luke Tilley said a 12% decline in gasoline prices in December and other decreases in energy prices — for expenses like home heating — helped drive inflation lower.

“Shelter is the main focus because of the lag,” he said. Rental market data shows a slowing in rates, but the CPI has not yet reflected it. “Everyone is familiar with the lag that it takes for the data to show up in the CPI,” Tilley added. “We think there could be a sharper slowdown.” Shelter costs are 40% of core CPI.

Shelter is expected to be up 0.6% month over month. Tilley said with the decline in the real estate market, he is hearing from landlords that they are having a more difficult time raising rents. “We’re penciling in slower increases in January and February and March on that shorter lag,” he said.

A focus on inflation in services

Economists are watching closely to see how much inflation related to services rises in CPI, since goods inflation is expected to continue to come down now that supply chains are operating more normally.

“The headline monthly changes over the last two, three months overstate the improvement. We’re not going to get the same help from gasoline in the next report. I don’t want to see an acceleration in shelter. I want to see some of the discretionary areas show deceleration,” said State Street’s Mocuta. “I think right now the focus is very much on the services side.”

The market is laser focused on inflation since the Fed’s progress in fighting it could determine how far the central bank will go on its rate hiking path. The rate increases are slowing the economy, and how much more it chooses to do so could be the difference between a soft landing or a recession.

“The hope is that basically we are now in a position where you could envision a soft landing. That requires the Fed to not only stop raising rates but ease up sooner and that doesn’t seem to be where they’re at,” said Swonk. “The Fed is hedging a different bet than the markets are. … This is where nuance is really hard. You’re in this position where you’re improving. It’s like a patient is getting better, but they’re not out of the hospital yet.”

The fed funds rate range is currently at 4.25% to 4.5%, and the central bank has forecast a final high rate of 5.1% for this year.

“The Fed is also worried about a second round of supply shock, whether it’s China’s abrupt abandonment of its zero-Covid policy or something else from Russia. They don’t want to declare victory too soon,” said Swonk. “They’re making that very clear. They’ve said it over and over again and nobody listens.”

Economists expect another key metric — the personal consumption expenditure deflator — could show core inflation slowing even below the Fed’s forecast of 3.5% by Dec. 31. Some economists who expect a recession predict rate cuts before year-end, as the markets expect. But the Fed has no forecast for rate cuts until 2024.

Some strategists expect Fed officials to begin to sound more dovish and less at odds with the market view. Boston Fed President Susan Collins said in an interview with The New York Times on Wednesday that she was leaning toward a quarter-point hike at the next meeting.

“We think one of the changes in coming months is the Fed will soon realize it is cheaper to change the inflation narrative than reverse a recession leading to millions of lost jobs,” writes Fundstrat founder Tom Lee in a note Wednesday.

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Oil expected to stay volatile in 2023, but the price could depend on China reopening

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Why everyone thinks a recession is coming in 2023

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People who lost their jobs wait in line to file for unemployment following an outbreak of the coronavirus disease (COVID-19), at an Arkansas Workforce Center in Fort Smith, Arkansas, U.S. April 6, 2020.

Nick Oxford | File Photo | REUTERS

Recessions often take everyone by surprise. There’s a very good chance the next one will not.

Economists have been forecasting a recession for months now, and most see it starting early next year. Whether it’s deep or shallow, long or short, is up for debate, but the idea that the economy is going into a period of contraction is pretty much the consensus view among economists. 

“Historically, when you have high inflation, and the Fed is jacking up interest rates to quell inflation, that results in a downturn or recession,” said Mark Zandi, chief economist at Moody’s Analytics. “That invariably happens — the classic overheating scenario that leads to a recession. We’ve seen this story before. When inflation picks up and the Fed responds by pushing up interest rates, the economy ultimately caves under the weight of higher interest rates.”

Zandi is in the minority of economists who believe the Federal Reserve can avoid a recession by raising rates just long enough to avoid squashing growth. But he said expectations are high that the economy will swoon.

“Usually recessions sneak up on us. CEOs never talk about recessions,” said Zandi. “Now it seems CEOs are falling over themselves to say we’re falling into a recession. … Every person on TV says recession. Every economist says recession. I’ve never seen anything like it.”

Fed causing it this time

Ironically, the Fed is slowing the economy, after it came to the rescue in the last two economic downturns. The central bank helped stimulate lending by taking interest rates to zero, and boosted market liquidity by adding trillions of dollars in assets to its balance sheet. It is now unwinding that balance sheet, and has rapidly raised interest rates from zero in March — to a range of 4.25% to 4.5% this month.

But in those last two recessions, policymakers did not need to worry about high inflation biting into consumer or corporate spending power, and creeping across the economy through the supply chain and rising wages.

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The Fed now has a serious battle with inflation. It forecasts additional rate hikes, up to about 5.1% by early next year, and economists expect it may maintain those high rates to control inflation.

Those higher rates are already taking a toll on the housing market, with home sales down 35.4% from last year in November, the 10th month in a row of decline. The 30-year mortgage rate is close to 7%. And consumer inflation was still running at a hot 7.1% annual rate in November.

“You have to blow the dust off your economics textbook. This is going to be be a classic recession,” said Tom Simons, money market economist at Jefferies. “The transmission mechanism we’re going to see it work through first in the beginning of next year, we’ll start to see some significant margin compression in corporate profits. Once that starts to take hold, they’re going to take steps to cut their expenses. The first place we’re going to see it is in reducing headcount. We’ll see that by the middle of next year, and that’s when we’ll see economic growth slowdown significantly and inflation will come down as well.”

How bad will it be?

A recession is considered to be a prolonged economic downturn that broadly affects the economy and typically lasts two quarters or more. The National Bureau of Economic Research, the arbiter of recessions, considers how deep the slowdown is, how wide spread it is and how long it lasts.

However, if any factor is severe enough, the NBER could declare a recession. For instance, the pandemic downturn in 2020 was so sudden and sharp with wide-reaching impact that it was determined to be a recession even though it was very short.

“I’m hoping for a short, shallow one, but hope springs eternal,” said Diane Swonk, chief economist at KPMG. “The good news is we should be able to recover from it quickly. We do have good balance sheets, and you could get a response to lower rates once the Fed starts easing. Fed-induced recessions are not balance sheet recessions.”

The Federal Reserve’s latest economic projections show the economy growing at a pace of 0.5% in 2023, and it does not forecast a recession.

“We’ll have one because the Fed is trying to create one,” said Swonk. “When you say growth is going to stall out to zero and the unemployment rate is going to rise … it’s clear the Fed has got a recession in its forecast but they won’t say it.” The central bank forecasts unemployment could rise next year to 4.6% from its current 3.7%.

Fed reversal?

How long policymakers will be able to hold interest rates at high levels is unclear. Traders in the futures market expect the Fed to start cutting rates by the end of 2023. In its own forecast, the central bank shows rate cuts starting in 2024.

Swonk believes the Fed will have to backtrack on higher rates at some point because of the recession, but Simons expects a recession could run through the end of 2024 in a period of high rates.

 “The market clearly thinks the Fed is going to reverse course on rates as things turn down,” said Simons. “What isn’t appreciated is the Fed needs this in order to keep their long-term credibility on inflation.”

The last two recessions came after shocks. The recession in 2008 started in the financial system, and the pending recession will be nothing like that, Simons said.

“It became basically impossible to borrow money even though interest rates were low, the flow of credit slowed down a lot. Mortgage markets were broken. Financial markets suffered because of the contagion of derivatives,” said Simons. “It was financially generated. It wasn’t so much the Fed tightening policy by raising interest rates, but the market shut down because of a lack of liquidity and trust. I don’t think we have that now.”

That recession was longer than it seemed in retrospect, Swonk said. “It started in January 2008. … It was like a year and a half,” she said. “We had a year where you didn’t realize you were in it, but technically you were. …The pandemic recession was two months long, March, April 2020. That’s it.”

While the potential for recession has been on the horizon for awhile, the Fed has so far failed to really slow employment and cool the economy through the labor market. But layoff announcements are mounting, and some economists see the potential for declines in employment next year.

“At the start of the year, we were getting 600,000 [new jobs] a month, and now we are getting about maybe 250,000,” Zandi said. “I think we’ll see 100,000 and then next year it will basically go to zero. … That’s not enough to cause a recession but enough to cool the labor market.” He said there could be declines in employment next year.

“The irony here is that everybody is expecting a recession,” he said. That could change their behavior, the economy could cool and the Fed would not have to tighten so much as to choke the economy, he said.

“Debt-service burdens have never been lower, households have a boatload of cash, corporates have good balance sheets, profit margins rolled over, but they’re close to record highs,” Zandi said. “The banking system has never been as well capitalized or as liquid. Every state has a rainy day fund. The housing market is underbuilt. It is usually overbuilt going into a recession. …The foundations of the economy look strong.”

But Swonk said policymakers are not going to give up on the inflation fight until it believes it is winning. “Seeing this hawkish Fed, it’s harder to argue for a soft landing, and I think that’s because the better things are, the more hawkish they have to be. It means a more active Fed,” she said.

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Defying forecasts, crude oil prices have wiped out most of this year’s gains and could head lower

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Tom Kaye of Plymouth, Pennsylvania tops off his neighbor’s gas tank for them on at a gas station in Wilkes-Barre, Pennsylvania, U.S. October 19, 2022. 

Aimee Dilger | Reuters

Oil prices are defying expectations and are barely higher on the year, as the outlook for oil demand continues to deteriorate for now.

West Texas Intermediate crude futures for January settled higher Monday at $77.24 per barrel, following a drop to $73.60 per barrel, the lowest price since last December. WTI was up 2.2% for the year, after briefly turning negative earlier Monday.

Gasoline prices at the pump have also been falling dramatically and could be cheaper than last year for many Americans by Christmas, according to an outlook from the Oil Price Information Service. On Monday, the national average was $3.546 per gallon of regular unleaded fuel, down from $3.662 a week ago but still higher than the $3.394 a year ago, according to AAA.

‘Macro headwinds rather than tailwinds’

China’s lockdowns and the rare protests against Beijing this weekend have raised more doubt about the outlook for the country’s already weakened economy.

“We think the recessionary [forces] around the world, particularly in the three largest economies, are dominating the macro environment for the year as a whole, and we think that the issues we’ve been identifying as relatively bumpy in the period ahead are going to remain,” said Ed Morse, global head of commodities research at Citigroup. “Right now, we are looking at macro headwinds rather than tailwinds.”

Morse was one of the more bearish strategists on Wall Street in 2022, but he said the latest market developments and the hit to major economies made even his forecast too bullish. He had revised his outlook higher at the end of the third quarter, based on the shift by OPEC+ to focus on prices and the pending ban of Russian crude by Europe.

The oil market has been focused on those two potential catalysts for higher prices, but the impact on demand from the slowdown in China and new lockdowns has outweighed concerns about supply for now. The European Union’s ban on purchases of seaborne Russian oil takes place Dec. 5. The EU is also expected to announce price caps for Russian crude.

OPEC+ is also a factor. The group includes OPEC, plus other producers, including Russia. The group surprised the market in October when it approved a production cut of 2 million barrels a day.

“We’re waiting to see if they signal even deeper cuts. There were rumors in the market about that happening,” said John Kilduff, partner with Again Capital. After dipping to the day’s lows, oil rebounded on Monday as speculation circulated about new OPEC+ cuts, he said.

Brent futures, the international benchmark, was lower Monday afternoon at $83.19 per barrel, recovering from $80.61 per barrel, the lowest price since January.

“Right now the target is below $60 [for WTI]. That’s what the chart is indicating… this is a new low for the move because previously the low for the year was late September and now we’ve broken that,” said Kilduff. “It all depends on what happens in China. China is as important on the demand side, as OPEC+ is on the supply side.”

Higher oil prices next year?

Analysts expect oil prices to increase next year. JPMorgan predicts Brent will average $90 per barrel in 2023.

Morgan Stanley expects the return of much higher prices mid-year, after China ends lockdowns.

“Our balances point to modest oversupply in coming months. Hence, we see Brent prices range-bound in the mid-80s to high-90s first,” the firm’s analysts wrote. “However, the market will likely return to balance in 2Q23 and undersupply in 2H23. With limited supply buffer, we expect Brent to return to ~$110/bbl by the middle of next year.”

Kilduff said he does not expect OPEC+ to make a big market impact this year with its cuts, though it is a wild card. Another factor that could drive prices would be if the war in Ukraine were to escalate.

“I’m not that worried about an OPEC+ cut just because the reality of it is most of the countries aren’t going to be cutting. It’s only going to be Saudi Arabia dialing back on the edges,” he said. “Everyone is so far into their quota. It’s a numbers game.”

Morse said market dynamics have changed and oil demand growth will be smaller as a percentage of gross domestic product. “We’re seeing a significant slowdown in global growth,” he said.

Oil demand growth for China turned out to be much less than expected. “We were thinking demand was sluggish. It turned out to be significantly more sluggish… We had thought this year was going to see 3.4 million barrels of demand growth. It actually grew by 1.7 million barrels,” Morse said. He noted that Europe’s demand is down by several hundred thousand barrels, and the U.S. was flat in 2022.

Morse said the demand decline is also part of bigger trend, tied in part to the energy transition toward renewables. “We are also looking for the peak of oil demand in this decade. It’s part of a longer term story,” he said.

The weather’s influence

Kilduff said La Niña’s weather pattern has also affected prices, with warmer weather in North America. He and other analysts say it could continue to impact the market.

“We keep getting cold outlooks, and then it falters. This is La Niña. You will get cold days, but then you get balmy stretches,” Kilduff said. He said concerns about winter heating fuel supplies have abated with a build in supplies in Europe.

The result for consumers could be a windfall at the pump during the holiday season. OPIS expects prices to keep falling into January before turning higher again.

“If you combine the Chinese demonstrations with the warm weather in the northern hemisphere, that’s kind of a double-barreled assault on the energy price at the moment,” said Tom Kloza, global energy analyst at OPIS. He said he expects gasoline to average between $3 and $3.25 per gallon at its low, but it will be below $3 in many parts of the country.

Kloza said by Christmas, the U.S. national average should be slightly below the $3.28 level it was at last year.

Diesel prices have also been falling. According to AAA, diesel averaged $5.215 per gallon nationally Monday, off by about 8 cents per gallon from a week ago.

“We’ve been counter-seasonally building distillate fuel supply so that’s been easing things. If the weather stays relatively benign here, we’re going to lose that upside catalyst and grind lower still,” said Again’s Kilduff.

–Michael Bloom contributed to this story.

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