Over the past 18 months, the Federal Reserve (Fed) has raised rates by 525 basis points (bps), its biggest tightening of monetary policy since 1981.  Long-term bond yields have also soared (Figure 1).  All but two other major central banks -- the Bank of Japan and the People’s Bank of China -- have also raised interest rates sharply (Figure 2). 

Figure 1: The biggest rate hikes since 1981 and a steep yield curve inversion

Figure 2: Rates hikes initiated nearly everywhere except China and Japan.

Yet, the U.S. economy continues to defy expectations.  It grew at nearly a 5% annualized pace in Q3 from Q2, and U.S. GDP expanded nearly 3% more than from a year ago despite the Fed rate hikes and a sharply inverted yield curve, which is traditionally considered a harbinger of economic downturns.  Should we be surprised? Absolutely not.  Here’s why:

  1. Long lags between rate hikes and recessions: The economy has never responded quickly to policy tightening, and the lag times appear to have grown since the early 1980s.  During the past three endogenous downturns (not counting the exogenous shock of Covid-19 in 2020), it took anywhere from 9 to 18 months after the Fed’s last rate hike to finally tip the economy into a recession (Figure 3).  Currently, we are about three months past the Fed’s most recent, and perhaps last, rate hike.
  1. Long lags between yield curve inversion and recessions: Yield curve inversions tend to foretell what the economy does roughly two years in advance.  Yield curves were inverted in 1988 and 1989, and there was a recession in 1990-91.  The yield curve inverted again in 1999 and early 2000, and a recession followed in 2001.  The yield curve inverted in 2006 and early 2007, and a recession began in December 2007 that lasted until November 2009 (Figure 4).
  1. This time might be different:  The fact of a still growing economy in the face of higher rates has activated the usual “this time is different” chorus to a fever pitch.  The lyric this time is about two themes that might allow the U.S. to avoid the usual post-Fed tightening cycle/yield curve inversion recession.  First, many large corporations refinanced themselves by issuing bonds at very low yields during the pandemic when long-term interest rates were at rock bottom.  Second, some argue that households are still sitting on piles of cash from the boom in savings during the height of the pandemic stimulus programs. 

Of the two “this time is different” arguments, the first is strongly supported by the evidence.  Many large corporations did indeed lock in inexpensive long-term financing when rates were low.

However, the same is almost certainly not true of small and mid-size firms, including the small caps in the Russell 2000, which has underperformed the S&P 500 and Nasdaq 100.  These types of companies rarely issue long-term bonds.  Rather, they tend to rely on bank financing.  According to the Federal Reserve Bank of St. Louis, the average length of a business loan is 749 days, which is about 23 months.  Coincidentally, this corresponds quite closely to the average lag time between Fed rate hikes (or cuts) and the eventual economic response. In any case, higher interest rates could force many small and mid-sized enterprises to make very difficult choices regarding staffing and investment in the coming years, which could contribute to higher unemployment rates and a retrenchment in both consumer spending and business investment. 

When it comes to consumers, how much cash reserves they have left after the pandemic is a subject of debate.  However, retail sales have not been growing quickly in volume terms.  Moreover, mortgage rates have soared from 2.9% to nearly 8% (Figure 5).  While this is of no consequence to the more than 90% of homeowners on fixed rate mortgages, new mortgage loan initiation has collapsed to its lowest point since 1995 (Figure 6) while sales of new and existing homes have plummeted (Figure 7).  Building permits and housing starts have also fallen (Figure 8). 

Figure 5: Mortgage rates have soared from 2.9% to over 8%.

Figure 6: Mortgage applications have fallen to a 28-year low

Figure 7: Existing home sales have fallen by more than one-third.

Figure 8: Housing starts and building permits have also dipped.

Adding to the mix, the average loan rate on credit cards has soared from 14.5% to 21%.  The average U.S. household had $9,228.38 of credit card debt as of the end of 2022, according to the Fed.  Financing that debt will cost the average American household an additional $640 per year going forward or about $78 billion across the entire population.  While this comes to only 0.3% of GDP, it comes on top of higher auto loans and renewed student loan payments as a possible brake on economic activity.

Overall, U.S. GDP growth was 2.9% year-on-year (YoY) in Q3 2023 but consumer spending growth was below average with just 2.4% YoY (it grew by 4% annualized in Q3 from Q2) while home building dropped by 7.8% YoY.  The main boost to growth came from a 6.3% rise in non-defense Federal government spending and a 4.9% increase in defense spending.  However, the boost to non-defense spending mainly came as a result of the Inflation Reduction Act, passed by the previous Congress; and the defense spending was in response to the Russo-Ukrainian war.  It seems much less likely that Federal spending will contribute so much to growth over the next four quarters given the changed political environment in Washington DC. Inventories also stacked up in Q3, potentially signalling slower growth going forward.

As such, when one looks at the forward curve, one must wonder if we will really have rates higher for longer?  Three months after the Fed stopped hiking in June 2006, the market priced that the Fed might eventually shave 25-50 bps off rates by late 2008.  Almost nobody saw the eventual cuts to (near) zero coming.

This time around, three months after the Fed’s (possibly) last rate hike in July 2023, the Fed funds futures curve looks strikingly similar, pricing a handful of cuts between now and late 2025 (Figure 9).  This is a reasonable forward curve for a soft landing with continued sticky inflation.  However, it is not one that prices any significant possibility of a recession (Figure 10).  Finally, it is worth pointing out that outside of rising rental costs, inflation in the U.S. has plunged to just 2.1% YoY and the rise in rental costs appears to have peaked about four months ago. 

Figure 9: Three months after the Fed’s 2004-06 tightening ended, investors didn’t price major cuts.

Figure 10: Fed funds futures pricing a soft landing – for the moment.

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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