The Fed Buys into the Soft Landing Narrative
Photo Credit: Sophie Backes, Unsplash
Investor sentiment has remained upbeat throughout 2023. Financial markets have rebounded from their 2022 sell-off, with the S&P 500 gaining more than 15% and credit spreads tightening. The Fed's tightening cycle is nearing an end, and its impact has been limited thus far compared to prior tightening cycles. The US consumer continues to be supported by low unemployment and wage growth. While data shows the economic activity rate is slowing, it remains positive despite the aggressive rate hike cycle. GDP growth has exceeded expectations, housing activity is rebounding despite elevated mortgage rates, and the industrial sector remains resilient as the government invests in infrastructure upgrades, renewable energy, and semiconductor production.
No Significant Changes to the Fed’s Forecast
Throughout the tightening cycle, the Fed has refrained from making significant changes to its forecast. Instead, it has consistently revised its outlook in response to hard data releases, such as job growth, unemployment, GDP growth, etc. What are the Fed's latest views? Based on the Summary of Economic Projections (SEP), you can add the Fed to the list of soft landing optimists. The following is a list of the major changes in the Fed's SEP since it was last updated in June:
The Fed funds rate is now projected to end in 2024 at 5.1%, up from the 4.6% estimate in June. With the increase, the Fed removed 0.50% of expected rate cuts in 2024. The increase is the Fed's way of communicating its 'higher for longer' view and warning the market that rates will have to remain restrictive for the foreseeable future. The market received the message, with the 10-year Treasury yield rising to 4.5%. The forecast for higher interest rates is quickly becoming a crowded trade, and as history has shown, crowded trades rarely play out as expected. From a positioning point of view, we continue to like long-duration bonds in the portfolio.
The Fed revised its 2023 and 2024 GDP estimates higher. The 2023 estimate was revised from 1% to 2.1%, and the 2024 estimate was revised from 1.1% to 1.5%. It is an acknowledgment from the Fed that the economy remained resilient in 1H 2023 despite higher rates.
The most notable revision relates to a change in the forecasted unemployment rate. The Fed now expects unemployment to peak at 4.1%, down from its estimate of 4.5% in June. However, history places a low probability of this forecast being accurate. History shows that once the unemployment rate rises above 4%, it peaks above 6%. It is challenging to manage unemployment, which is a lagging indicator, and we expect this cycle to be the same. The Fed's revised SEP suggests it does not believe higher rates are making an impact. However, the data says otherwise.
The Fed Needs Patience
In September, homebuilder sentiment weakened for a second consecutive month after strengthening throughout 1H 2023. A downturn in soft data like homebuilder sentiment has historically signaled that an economic rebound is not sustainable. The chart below shows August housing starts fell to the lowest level since June 2020. Delinquencies, bankruptcies, and loan loss provisions also highlight the Fed's progress. Data from the New York Fed reveals that credit card delinquencies are rising across every age bracket, and the number of business Chapter 11 bankruptcy filings continues to rise. Additionally, banks are increasing their loan loss provisions, and falling commercial real estate prices could increase the need for additional loan loss reserves.
US Housing Starts vs Building Permits
The chart below shows August housing starts fell to the lowest level since June 2020
Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
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