Don’t Fight the Fed

Saraja Samant: Hello, everyone. I’m Saraja Samant from Morningstar. The past couple of months have been really difficult for the market with the banking turmoil on one hand and inflation volatility on the other. Joining me today to make sense of the current market conditions and how the Fed actions impact them is Tiffany Wilding from Pimco. She is a managing director and economist there.

Tiffany, thanks for being here.

Tiffany Wilding: Thanks for having me.

The Federal Reserve and Rising Interest Rates

Samant: Yeah. So, to get right to it, my first question for you today is, What does it mean when we say ‘listen to the Fed,’ and what message does the recent Fed hike give out to the market?

Wilding: There’s a lot to unpack with that question, certainly. I think when people say ‘listen to the Fed,’ I think there’s a lot of things that they’re thinking about. Ultimately, whenever we’re trying to forecast the economy or monetary policy decisions, it’s not actually just the Fed that we’re listening to. We’re also looking at the economic data; we’re doing the forecasts ourselves; we’re trying to understand what the current conditions suggest to us about the future. So, when we listen to the Fed, we try to understand what their current views are based on the data that’s coming in, but not only that, as the data changes and it becomes different than their own baseline forecast, how will they react to that. So, that’s what we’re trying to do on a real-time basis all the time.

In terms of what the latest rate hike tells us, I also think it tells us a couple of things. The answers are never simple, of course. I think, first of all, the fact that the Fed is continuing to hike interest rates I think is symptomatic of the fact that we just have high inflation still. So, not only the Fed but central banks across developed markets have had a very strong policy response to what is the most elevated rate of inflation that we’ve seen in several decades. And so, the Fed is still responding to that. And of course, with core CPI inflation at 5.5% still, they still have some work to do. Now the fact that the rate hike was only 25 basis points and not 75 or not 50, I think also tells us something here and that is that the Fed already thinks that they’ve gotten policy into restrictive territory more or less. So, now, they’re slowing down the pace of those rate hikes in order to more strongly balance the potential for them to overdo it versus the elevated inflation that we currently have.

The Fed Meeting

Samant: All right. Thank you so much. Just to pick it up from what you said right now—that they are probably slowing down their pace—so, there was also a change in the Fed’s tone in the recent meeting where it actually suggested forming the policy rather than continuing with the ongoing hikes. So, having all that background, do you see the interest-rate peak coming sooner now than before?

Wilding: Yeah. Well, there’s certainly been various developments that have happened that I think probably will result in the Fed maybe doing one more rate hike but potentially even being on hold after this most recent hike. Of course, we came into the year with economic data in the United States that was revised higher that just showed more momentum. Obviously, the labor market was very resilient. So, coming into the turn of the year this year, it actually looked like the Fed could even go higher than they had previously been forecasting. But now, in the last couple of weeks, obviously, we’ve had elevated stress within the banking sector, particularly regional banks. That spilled over into the European banking sector market, obviously, with the weekend merger of Credit Suisse and UBS. Overall, all this does is raise the cost of capital for the banking sector, and ultimately, that’s going to slow loan growth. They’re going to pass that on to businesses and consumers through higher rates and slower loan growth, and that’s ultimately going to be a drag on the economy.

What this most recent stress is basically suggesting or what we think should be suggesting to the Fed is that they ultimately have to do less heavy lifting on the policy rate themselves in order to get a similar outcome. So, yeah, we think the Fed, if not being done is almost done with their rate hikes. One last word on this is that slowing down or even stopping on hikes doesn’t necessarily mean that the Fed is going to turn around and aggressively ease, and that’s even despite the banking stress. And that’s just because, like I said before, inflation is still elevated. So, the Fed was really still having to weigh inflation risks versus financial stability risks. And obviously, if banking sector stresses don’t really escalate more from here, it’s probably still going to take inflation coming down more toward target for them to actually start cutting rates or normalizing policy.

Banking Sector Stress and Recession Worries

Samant: All right. Thank you so much. And as you mentioned with the banking sector stress and the economy slowing down, the chances of recession are higher now than before. And everyone seems to keep talking about the recession coming up. But we are still seeing plenty of jobs, people still going out to the mall, basically the demand still being there. So, why is that?

Wilding: What’s interesting is that—so, last October, we came out with our detailed forecast or outlook for 2023. In that essay, we effectively wrote about the high probability of recession in 2023. And the reason why we thought that is because monetary policy works through lags. The Federal Reserve was clearly doing a lot to bring down inflation, and the tighter financial conditions that have resulted from that, in our view, would probably be enough to bring the economy down into a modest recession. We had actually on the basis of that analysis with some historical look across 14 developed economies the last 70 years, which suggested to us that recessions tended to come two to two-and-a-half years after central banks started rate-hiking cycles and that you saw more a material deceleration in the output gap around six to eight quarters after. So, that suggested in 2023 we should start to see this deceleration.

Now, we didn’t forecast the specific idiosyncratic factors with the Silicon Valley Bank or Signature Bank or whatnot, but nevertheless, I think the timing of the stress and slowing of activity within the banking sector is kind of consistent with historically what we’ve seen around hiking cycles. So that, in our minds, all suggested that and still suggests that the probability of recession this year is elevated. Now, I will say, I think that the probability of a more severe recession probably also increased. It’s been very eye-opening in our minds how quickly the situation has escalated and obviously how quickly you had a loss of confidence in Credit Suisse. Obviously, we also had a little bit of a scare with Deutsche Bank in Europe, and then the U.S. banking sector has also seen a confidence shock as well. So, I definitely think that along those lines it’s certainly possible to have a more severe recession as well.

The Bond Market and Economic Slowdown

Samant: All right. Thank you. And yeah, you answered my question right there. I was just going to ask how deep of a recession are we looking at here. But it looks like a severe recession could also be in the picture going ahead. Thank you for that. Just one last question for you: In such recessionary scenarios, what kind of investments are the most attractive, and where do you think will it pay off to actually take the risk?

Wilding: Yeah. Well, before I get to that, if you don’t mind, let me actually just kind of go back to your question on how deep of a recession, because I still think it’s an interesting question. Ultimately, we think it’s still probably going to be shallow, and again that assumes that you don’t have additional escalation in banks, you don’t have large U.S. banks that are coming under pressure, etc. The reason is because there’s still a lot of positive, what I would call, economic overhangs leftover from the pandemic. You still have consumers on average that have elevated savings. There is still pent-up demand, I think, as a result of the fact that people just couldn’t get the stuff that they wanted in the wake of the pandemic because of some of the supply constraints. So, that is still having a positive effect on the economy.

In addition to that, at least large corporate balance sheets are relatively strong. Even some of the smaller businesses that will be more impacted by this banking sector stress, they were actually really able to repair their balance sheet as a result of the PPP loans and other supports during the pandemic. All of that taken together again suggests to us that if we have a recession, it is going to be a mild one.

But then you asked, what is the kind of investment framework or strategy that we’re really focused on in this kind of environment. It’s really one that takes into consideration obviously these macro trends but also starting levels in valuations. And there, when we look across markets, we really see a lot of value in bonds and particularly high-quality bonds. So, obviously, the Federal Reserve and central banks across developed markets raised rates tremendously. That has resulted in real interest rates that are the most elevated that they’ve been in quite some time. So, with starting yields that are actually relatively high, not only in the government-bond market but in high-quality credit markets as well, high-quality securitized markets, it’s a nice time, we think, for investors to allocate back to higher-quality bonds within their portfolio. And we do think the diversification benefits of this asset class are coming back. Of course, last year, bonds as well as equities as riskier assets sold off in tandem, and that was because of what central banks were doing. They had to tame inflation. But this year, as we go through the year, we go through a recession, the central banks will be much more focused on both sides of their mandate, and we think that will return the historical correlation to bonds as being a good hedge for your risky asset portfolio. So, all of that suggests to us that bonds are back as we say.

Samant: All right. Thank you so much. This has been great. Thank you for your insights, Tiffany, and thank you for joining us today.

Wilding: Thanks for having me.