Will the Fed successfully win the fight against inflation without necessitating a recession? The stock market seems to think so.
Last month, the S&P 500 in the United States jumped by another 3.1 percent after it was announced that June inflation fell to 3 percent, which was lower than consensus estimates. The index’s strong performance in July brought its year-to-date gain to 19.5 percent.
While I normally agree with Mr. Market, this is one of the few times I disagree.
Although inflation is undoubtedly headed lower, I think the US economy is still at risk of entering a recession, mainly because of the Fed’s aggressive tightening cycle.
Interest rates work with long and variable lags, and historically, there were only three times that the Fed rate hiking cycle did not result to a recession—1964, 1985 and 1995.
The main difference during those three times was that the difference between the 10-year and the 2-year bond yields never turned negative or the yield curve never inverted. This was because the Fed did not have to raise rates too much to control inflation.
Every time inflation turned very hot like it did last year, the Fed raised rates aggressively. This led to the inversion of the yield curve and the US suffering from a recession.
Note that the yield curve has been inverted since July 2022. Although it’s been 13 months since the starting date, recession is still a possibility since in that past, the time it took for the recession to begin since the yield curve started to invert ranged from as short as six months to as long as 33 months.
Moreover, although there are numerous reasons why the Fed should already pause or stop raising rates, including the peaking and continuous decline of inflation, falling housing prices, the tightening of credit standards, the collapse of several banks, the decline of the leading economic indicator and negative money supply growth, the Fed continues to tighten.
This is because the Fed is squarely focused on the unemployment rate which remains very low. However, I don’t think the unemployment rate is a good measure of economic strength as it is a lagging indicator.
Consequently, unless a recession materializes causing the unemployment rate to go up sharply, the July rate hike probably won’t be the last. If the Fed continues to raise rates, it will put additional pressure on the economy, further increasing the risk of a recession.
Given the elevated risk of a recession, the strong performance of the US market will most likely be short lived.
Because of this, it’s still a good idea to keep some cash, especially with the very high yields on bank placements. Having cash gives investors dry powder that they can deploy when stock prices go down because of a recession.
Meanwhile, investors who continue buy US stocks should not adopt a long term buy and hold strategy. Rather, they should act more like traders, being quick to cut losses or lock in gains.