The Fed Raised Rates in a Bear Market and Maybe a Recession

Investors got what they thought they wanted – a 75 basis point rate hike.  Then the reality set in.  The Fed raised rates amidst a bear market.  And it may turn out that they raised rates in a recession.  Neither is easy to swallow.

For the two hours after the Federal Reserve announced that it was raising its benchmark rate by a then-expected 0.75%, it appeared as though Chairman Powell may have pulled off an escape worthy of Houdini.  The recent spike in rates and plunge in risk assets was attributable to investors’ recalibrating their rate hike expectations from 50 to 75 basis points, so it was understandable that the initial reaction was a bit of a bounce.  “Sell the rumor, buy the news” is just as valid as it’s more well-known inverse.  Unfortunately for those who bought into yesterday’s rally, it has proven to be another head fake similar to the one we saw after the last FOMC meeting.

It seems that as investors reassessed the economic backdrop, they realized that yesterday’s rate hike was very difficult medicine to swallow.  (A surprise rate 50 bp hike by the Swiss National Bank – the first hike in 15 years – did not help sentiment).  Indeed, central banks need to do their parts to dampen inflationary pressures, but while higher interest rates affect the inflation that arises from too much money chasing too few goods, they do nothing to increase the supply of available commodities that might be in shortage.  Chairman Powell acknowledged that during his press conference. 

We need to keep this uncomfortable fact in mind – the Fed raised rates during a bear market.   This is something that hasn’t happened in decades.  It was in response first to the 1970’s oil shock and the embedded inflation of the early 1980’s.  It was painful then, and it is proving painful now.  The vast majority of current market participants have simply not seen conditions like that.  For most of the past few decades, certainly since 2009, we have been in an environment when central banks were generally accommodative – sometimes incredibly so.  There were a few times when the Fed and others attempted to raise rates and withdraw liquidity, but were able to backtrack at the first signs of trouble because inflation was generally quiescent.  Now they simply don’t have that luxury.

Even worse, we learned late yesterday that we may be even closer to a recession than we thought.  Bear in mind that the textbook definition of a recession is two consecutive quarters of negative GDP growth, and that we saw a -1.5% drop in the first quarter of this year.  We noted yesterday that the Atlanta Fed’s GDPNow forecast for the second quarter GDP was a modest rise of 0.9%, and that the estimate was made on June 8^th, before the parlous CPI and Michigan sentiment numbers.  They updated the forecast yesterday (June 15^th), and it now shows an anticipated 0,0%.  Yes zero.  In other words, we are an eyelash away from a recession.  And it seems reasonable to expect that a rate hike and further market selloffs could push that number into negative territory.

I don’t mean to be so grim, but there is no way that I can find a useful spoonful of sugar to help this economic medicine go down.  Neither could Chairman Powell.  Goldilocks, maybe.  Mary Poppins, no.