Recession, inflation or both?
What two bad days have taught us
Friday morning’s inflation report was a surprise. The market response to it stuck to the standard script. In conceptual, if not temporal order, what happened was as follows:
First, expectations for rate increases changed, a lot. A week ago, the futures market implied a 3 per cent chance of a 75 basis point increase, and a 97 per cent chance of a 50 point increase, when the Fed meets later this week. Now the odds are 28/72. The market implied fed funds rate for February 2023 has moved from 3.1 to 3.9 per cent.
Next, the Treasury curve moved, a lot. Rates leap at all maturities, but fastest at two and five years, flattening the belly of the curve.
Next, equities fell, a lot. The S&P dropped 6.8 per cent over two days. Everything went down, but value fell less than growth, and big caps fell less than small caps. Here is the sectoral breakdown:
Note the familiar pattern: the growths stuff that did so well in the coronavirus pandemic sold off the hardest (the consumer discretionary sector is 43 per cent weighted to Amazon and Tesla).
We have seen all of this before, more or less every other time the inflation data has come in hot. Indeed, most of the S&P down days seem to follow this sort of pattern. Rate expectations up, stocks down, yields up, yesterday’s winners become today’s losers.
A question remains, though. Is this an inflation scare, a Fed-induced recession scare, or some of both?
The market provides a few useful, if inconclusive, clues. First, break-even inflation has not moved much. The big jump in five-year Treasury yields, for example, has been mirrored by the jump in five-year inflation-protected Treasury (Tips) yields, leaving implied inflation flat:
We’ve argued in the past that Tips yields are probably a distorted indicator of investor expectations. Still, this chart is probably telling you something, directionally at least. It may be saying, “The Fed is going to raise rates, but inflation will not get out of control.” Or it may be saying, “Inflation volatility is going up, so real rates have to rise to reflect that risk.” Probably it is some of both. But either way, it is not screaming that inflation is going higher.
Next, consider corporate bonds’ yield spreads over Treasuries. They have been moving higher, and in a specific way. The spread between spreads has been increasing. That is, lower-quality bonds are seeing their spreads move higher faster than higher-quality bonds.
Below is the difference between investment-grade spreads and spreads just of the lowest rung of investment grade, or BBBs; the difference between BBB and the highest grade of junk bond, or single Bs; and between single Bs and the lowest grade of junk, of CCCs:
When the spread between spreads widens like this, that is telling you the economy is going to get worse and defaults are going to rise. These data only go through Friday, but a reliable bond trader contact said these gaps kept right on widening.
Both of these points suggest that the market is primarily afraid that the Fed will tighten the economy into recession, rather than fearing that inflation will spin out of control. But on the other hand, if inflation was not a worry, you might expect the 10-year Treasury to catch a bid, rather than selling off hard. And you wouldn’t expect Fed fund futures to rise so sharply. So the picture is mixed. Recession is the primary risk, but the chances of a recession accompanied by high inflation — stagflation — are moving up too.