For most of the last quarter century, real short-term US interest rates have been low or negative, except when monetary policy was being tightened. Today, market pricing expects real short-term rates to remain positive. That is consistent with a soft landing rather than a recession. Bonds have performed well on the back of dovish rate expectations and softer economic data. The curve has bull steepened i.e. short-term yields have fallen faster than long-term yields. To sustain such returns and for rate expectations to price in even lower real short-term rates, there would need to be evidence that recession risks have increased. The problem with that is risk assets tend to underperform when the economy flirts with recession. September is seasonally bad for risk assets, the Federal Reserve’s Beige Book – its summary of current economic conditions – suggested the US economy was soft, and we have had spikes in equity volatility in recent weeks. As the US Treasury yield curve dis-inverts, is it time for more caution?
If the US economy avoids a hard landing, equities should continue to outperform bonds. We are not in a recession. The soft landing scenario is very much priced in and for the US at least, the data suggests it might be the softest of soft landings. The recession – if there is to be one – is delayed. Interest rates might have peaked but a long plateau could be ahead of us.
Frontiers
Markets are probing the frontier between what constitutes a US economic soft landing and a recession. As usual, the rates market is leading the exploratory expedition, having already priced in aggressive cuts in policy interest rates in the year ahead. By the end of 2025, the Fed’s key policy rate is expected to be targeted at 3.0%, a full 250 basis points (bp) below where it stands today. The market expects that process of rate cuts to start on 18 September, pricing around a 70% chance that the Fed cuts by 50bp, although a 25bp reduction seems more likely. Looking out along the forward curve, we can observe four 25bp cuts priced in for the remainder of this year and five additional cuts in 2025. The next step on this journey is how the Fed presents the rate cut on 18 September – its Beige Book released on 4 September was downbeat in terms of activity and the jobs market.
Real rates
Is a recession priced? It’s not clear that it is yet. Real short-term rates are expected to remain positive on the assumption that the core personal consumption deflator inflation rate settles back to the target of 2.0%. A 1% real short-term policy rate is higher than the average of the last 30 years (0.6%) and much higher than the average of the last 20 years (-0.4%). The experience since the late 1990s has been one of prolonged periods of negative real interest rates interrupted by sharp increases in real rates during Fed tightening cycles. There is little evidence to suggest that 1% real short rates represent any kind of equilibrium.
Economic cool spots
For now, the economic numbers are not aligned with a full-blown recession. The US economy grew at an annualised rate of 3% in the second quarter (Q2). Recession is not the central view of AXA IM. But there are concerns about a slowdown and these are focused on the manufacturing sector and the labour market.
Also read: Beware Outdated Perceptions When Comparing Credit Markets
Year of the bond
Recent market performance is aligned with slower growth. The shift in rate expectations in Q3 generated very strong return numbers in the bond market. As we have expected for some time, the US yield curve has started to normalise – the gap between two-year and 10-year Treasuries is now close to zero compared to 100bp in early 2023.
Volatility signals
August and September’s first trading weeks saw increased equity market volatility. I still like credit as an asset class but the ability of credit to deliver returns substantially more than rates when credit spreads are already thin, and the economy is slowing, must be questioned. If you take the ISM data seriously and couple that with a weaker labour market, the conclusion is a slowing economy that will raise the uncertainty over credit stability and corporate earnings growth going forward. Risk premiums are low. One could conclude a more cautious approach is required.
Adjustment from expensive
US markets have been more expensive than the rest of the world. The justified price-to-earnings valuation premium of US stocks rests both on the preponderance of growth stocks in the US market but also on the aggregated rate of growth of earnings. The growth stocks story isn’t going away, but earnings growth might be at risk from a slower economy. US credit spreads have been, mostly, narrower than in other credit markets. If the economy is downshifting from 3% GDP growth, low unemployment, and double-digit earnings growth to something softer, then some rebalancing of valuations between US and other markets might occur. Another consideration is politics. The political climate is not great anywhere, but the US has an event upcoming which creates uncertainty over the direction of the policy agenda.
Inertia
The lesson learned in recent years is that economic inertia is not something that models always pick up easily – the inflation shock went further and lasted longer, the post-pandemic jobs boom lasted beyond what seemed likely, and maybe now the slowdown might go further, taking interest rates lower and potentially risk premiums higher. A theoretical 60:40 balanced portfolio of equities and bonds would have performed well in 2024. If risk asset performance starts to deteriorate, bonds are in a better position today to provide some cushion of portfolio support compared to the case for most of the last 20 years.
(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 5 September 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.)
