Fed on track to cut rates as US economy teeters on brink of recession
The “Sahm rule” suggests the US may be near a recession, and any sharp increase in unemployment will likely be met by aggressive Fed rate cuts. Christopher JoyeColumnist
Jul 12, 2024 – 10.13am
The US Federal Reserve is paving the way to cut rates in September, just two months ahead of a US presidential election that many think Donald Trump will win.
A politically sensitive Fed has been desperate to cut its policy rate all year from its lofty 5.25 to 5.50 per cent range (notably 100 basis points above the Reserve Bank of Australia’s globally low cash rate).
These plans were kiboshed by a reacceleration in core inflation in the first quarter of this year as a result of sticky demand-side services costs, which were being powered by elevated wage growth that was itself an artefact of a tight labour market. But the data has started to demonstrably shift as the Fed’s tight monetary policy settings inevitably have an impact.
The jobless rate in the US has climbed appreciably from its 3.4 per cent trough in April last year to 4.1 per cent in June, seemingly following the trajectory of New Zealand’s unemployment rate, which has risen from a nadir of 3.2 per cent to 4.3 per cent.
The Reserve Bank of New Zealand lifted rates well before most peer central banks to a globally lofty 5.5 per cent. On Coolabah’s estimates, this has likely pushed the economy into recession in the name of taming the worst inflation crisis in decades.
Our research suggests that the gradual increase in US unemployment has almost satisfied the “Sahm rule” test that has historically been the best guide to the onset of a recession. Sahm rule has identified US recessions
The current unemployment rate of 4.1 per cent also hints that the US labour market may be moving back into balance given it is very close to the Fed’s figuring of “full employment”, which it puts at just below 4¼ per cent.
The three-month average increase in US unemployment of 0.4 percentage points above the low point of the past year has almost triggered the 0.5 percentage point threshold that signifies the start of a recession, according to the Sahm heuristic.
Since 1950, the Sahm rule has correctly identified the inception of all US recessions with arguably few false signals. “The Sahm rule of thumb is not precise, mainly because of how it is calculated, and there is no guarantee that it will continue to hold in the future,” said Kieran Davies, Coolabah’s chief macro strategist.
“Nonetheless, it does better than any other economic indicator in providing a timely signal of recession. This reliability reflects the fact that every sharp rise in the US unemployment rate in the post-WW2 period has been driven by the job losses that are the hallmark of a recession.”
The infamous inversion of the US yield curve, where 10-year government bond yields fall below short-term rates – presaging future rate cuts – has since 2022 indicated that the US would likely experience a recession in late last year or early this year.
The delay in the advent of a recession could be attributed to the fact that US consumers built-up record cash buffers during the pandemic worth the equivalent of two years of economic growth, which they spent over 2022 and 2023, bolstering demand. Fed focused on potential Trump return
The economy has also been bailed out by extraordinarily stimulatory fiscal policy. President Joe Biden ran a budget deficit worth an incredible 6 per cent of GDP. So-called “soft-landings”, which involve situations where the Fed tightens policy without precipitating a recession, are historically very rare.
It is important to understand that any meaningful expansion in the unemployment rate beyond the Fed’s full-employment estimate will likely be met by more aggressive cuts than it is currently projecting. This is because the Fed’s forecasts assume that the jobless rate remains in the low 4 per cent zone.
During bona fide recessions driven by job losses, the Fed has typically cut rates by a chunky 5.4 percentage points. In contrast, the three soft landings that we have identified since 1950 have been accompanied by only modest cuts worth 1.6 percentage points.
The Fed has nevertheless been uber-keen to chisel rates lower ahead of the presidential election in November. Donald Trump has stated that he wants to crimp the Fed’s policy powers and remove Jerome Powell as chair, which at the margin seems to have delivered a more dovish central bank.
On Thursday night, the core CPI data for June hit a very benign 0.1 per cent, below consensus forecasts of 0.2 per cent. On a six-month annualised basis, core CPI in the US has been running at 3.7 per cent (year-on-year it has printed at 3.3 per cent). Nothing resembling a ‘landing’ so far
Yet, the monthly outcomes have declined consistently over the past three releases, resulting in a quarterly annualised pace of 3.2 per cent. While the allure of the Fed lowering rates at its 17-18 September meeting has supported the risk rally, it is not clear whether we will get deep cuts or the much more modest outcomes associated with soft landings.
We have not, thus far, had anything remotely resembling a “landing” as such considering core inflation has not sustainably settled at the Fed’s 2 per cent target.
The RBA is in the invidious position of having to tackle seemingly much higher inflation while maintaining far less restrictive policy given its globally low 4.35 per cent cash rate.
If the June quarter underlying inflation data released later this month lands at either 1 or 1.1 per cent, as our forecasts portend, the RBA will come under tremendous pressure to correct its policy errors by lifting interest rates broadly in line with peers overseas.
This higher-for-longer rate climate, along with a further increase in the jobless rate, is likely what will be required to normalise inflation. And it will subject riskier, peripheral areas of the economy to non-trivial stress. This is already playing out via a large increase in defaults on sub-investment grade bonds and loans written by non-bank lenders.
During the week, one of the world’s biggest bond managers, PIMCO, sensationally published analysis arguing that the extra return, or risk premium, investors are getting on illiquid private credit portfolios is woefully inadequate. Private credit risk writ large
“Based on the significant deal flow we are seeing across markets, we observe that the liquidity premium in many areas of private markets has tightened to unattractive levels,” wrote PIMCO’s Mohit Mittal. “We are also seeing deterioration in covenants that traditionally protected lenders in private credit markets,” he continued.
PIMCO estimates that private credit should pay a risk premium of at least 200 basis points a year over public (or liquid) credit to compensate for “the cost of lost alpha from active management of fixed income portfolios, the cost of the inability to rebalance portfolios, and the cost of liquidity shortfalls for unexpected liquidity needs”.
Yet, they find that the “liquidity premium in investment grade segments of private credit markets has tightened to less than 100 basis points”.
“We believe that level is insufficient relative to the opportunity costs associated with rebalancing, lost alpha from public fixed income, and potential costs of cash shortfalls,” warned PIMCO.
We have been making similar points for some time. What is even more worrying is PIMCO’s analysis showing that the share of private credit borrowers who cannot service their debts at current rates has jumped from 16 per cent a couple of years ago to 40 per cent this year.
This echoes our research on the share of listed “zombie” companies globally that have insufficient profits to pay the interest on their debts, which has doubled over the last decade.
“The percentage of private corporate direct lending borrowers with fixed charge coverage ratios below 1x has risen from 15 per cent two years ago to 40 per cent this year,” said PIMCO.
“This means 40 per cent of private credit borrowers (size weighted) are not producing enough cash flow to service all debt, taxes, and capital spending needs”.
“If interest rates stay elevated for longer or economic growth slows, these borrowers would be more vulnerable to further increases in leverage, declining credit quality, and higher expected losses.”
