Worries of Recession Amplified by March FOMC Minutes

QUICK LOOK:

• The FOMC Minutes are a report that details the range of different committee member viewpoints from the prior Fed meeting.
• March’s FOMC minutes (released Wednesday) revealed that many officials wanted to raise rates by 0.50% last month.
• Russia’s invasion of Ukraine caused Fed officials to err on the side of caution, leading to a 0.25% rate hike instead of 0.50%.
• Many officials believe the next rate hike, likely in May, should be 0.50%.
• Fed officials plan to reduce balance sheet by $95 billion per month
• Aggressive rate hike rhetoric has upended the stock market, sending bonds soaring, and leading many to worry about a possible recession.
• “We anticipate a more aggressive tightening of monetary policy will push the economy into a recession,” said Deutsche Bank economist Matthew Luzzetti.

Some economists fear that raising rates too fast could have a disastrous effect on the stock market, impacting earnings growth and possibly causing a recession.

The market is all-in on the Fed lately. Ever since some of the Fed’s most dovish officials (Lael Brainard and Mary Daly) started making hawkish comments about upcoming rate hikes, the market has been in a tailspin. The major indices are down multiple percentage points for the week, and bonds are trading at their highest point since early 2019. 

Wednesday’s release of March’s FOMC minutes confirmed what Brainard and Daly were talking about. In its most hawkish note since the beginning of the pandemic, the Fed set the stage for a steep reduction of assets in the central bank’s balance sheet, and upcoming rate hikes twice the size of the one from last month’s meeting. 

The minutes also shed light on the reason for last month’s quarter-point rate hike — the Russian invasion of Ukraine. But now that the situation has begun to stabilize, Fed officials are looking to ramp up the pace of change heading into next May’s meeting. 

In a nutshell, the March FOMC minutes all but confirm that the market is in for a more aggressive path toward monetary tightening than originally thought. 

But why does the Fed’s new hawkish tone have economists and investors so worried? The answer is twofold.

Weakened Earnings Outlook For Growth Stocks

Companies that have not yet reached a sustainable level of profitability — especially those that are not producing any profit — are often the first targets for short-sellers and put buyers on rate-hike-related news. The reason why is simple: they’re highly reliant on borrowed money.

Taking out loans while money is cheap, and forecasting earnings based on that “cheap money” can lead to accelerated growth expectations. For instance, if a business is pricing in the ability to take out low-interest loans next year, that’s going to have a positive impact on revenue. 

Contrarily, higher debt expenses (triggered by higher rates) often lead to lower revenue, and decreased future cash flows for the business. This can have a cascading effect on the earnings outlook of a stock. Earnings guide-downs are a recipe for lower stock prices.

But it isn’t just growth stocks that economists are worried about. If the Fed pushes the envelope on economic policy too fast, the entire stock market could bear the brunt.

Fears of a Recession

Before we look into the risks presented by a recession, let’s first define what a recession is.

A recession is defined as a decline in GDP over two back-to-back quarters.

The result? A period of temporary economic decline during which trade and industrial activity are greatly reduced. And there are signs that this is exactly where the economy is headed.

Last week, the market flashed a bold, frightening indicator when the 2-Year Treasury Yield briefly surpassed the 10-Year. This is called an inverted yield curve. It’s an indication that investors are getting pessimistic about long-term economic prospects, and it’s typically a sign of a coming recession. 

This has analysts at Bank of America worried about a fundamental weakness growing within the economy. Though the team at BofA is concerned about a potential downturn in the market, they stopped short of calling for a recession. The same could not be said of Deutsche Bank. 

Tuesday, Deutsche Bank became the first major financial institution to call a 2023 US recession their “base case”. 

“We anticipate that a more aggressive tightening of monetary policy will push the economy into a recession,”

said Deutsche Bank economist Matthew Luzzetti.

This would not be good news for Deutsche Bank, or any bank. While rate hikes would traditionally be positive for the financial industry, in a recession, banks are often among the hardest hit. 

Impact of Rate Hikes and Recession on the Financial Sector

First, let’s start with rate hikes. If recession fears abate, financials could stand to benefit from increased interest rates. Banks, brokerages, and mortgage companies base much of their earnings on how much they stand to gain from providing loans. 

If “the cost of money” is a concern for growth stocks, you can think of these businesses as the providers of that money. As a result, they may see their earnings revised higher if rates are raised in a meaningful way. 

Of course this hinges heavily on the US economy remaining strong, and recession fears subsiding. If that doesn’t happen, and the economists at Deutsche Bank are correct, then all of the benefits of rate-hikes for banks will be outweighed by the effects of a recession. What good are more expensive loans if fewer consumers can afford to take them out, and those that already have them are defaulting at a higher rate? 

The effects of rate hikes are already beginning to take their toll on the mortgage industry. 

On Wednesday, a report was released showing that the average interest rate for a fixed-rate mortgage increased by ten basis points this month, to 4.90%. Applications to refinance a home loan, which have already been falling steadily in the face of aggressive rate hike rhetoric, fell another 10% week over week. Mortgage applications fell 3% this week, and are 9% lower year over year. 

Indicative of slowing economic growth, this is not a good sign for lenders in the financial industry. 

Not everybody believes we’re headed for a recession

One person who doesn’t think we’re on a crash course for recession is the man behind the policy changes: Fed Chair Jerome Powell. 

During last month’s Fed meeting, Powell offered this rebuttal to a question about whether the economy was at risk of recession:

“In my view, the probability of a recession in the next year is not particularly elevated. Aggregate demand is currently strong and most forecasters expect it to remain so. If you look at the labor market, it is also very strong. Conditions are tight, and payroll job growth is continuing at very high levels. Household and business balance sheets are strong. And so, all signs are that this is a strong economy.”

He isn’t alone in this opinion. In the same speech where she called for an increased pace to upcoming rate hikes, Fed President Mary Daly said,

“There is a lot of momentum in the economy. I’m not expecting that we will fall into recession.” She continued, “We could slow so it looks like we’re teetering close to it. That’s possible. But it will be a short-lived event, I expect we’ll be back up.”

The Bottom Line

With a rise of fearful analyst predictions and scary headlines, it can be easy to lose your head. In case no one has reminded you today, don’t trade on emotion! If you’re feeling worried, you should evaluate why that is. Are you in a risky trade? Do you have a lot to lose? If the market were to take a turn for the worst tomorrow, would you be knocked out of the game?

If you answered yes to any of these questions, you don’t need to panic, but you should reevaluate your trading strategy. Trading shouldn’t be stressful. There should never be a situation where, if a trade goes against you, you’ll lose a large portion of your portfolio. 

Trading with discipline is hard, but it’s discipline that will keep you alive through the many twists and turns of the market — and help you sleep at night. Interested in developing a custom trading plan? Take this trading quiz to find a strategy that fits your needs.