Wits Trajectories, headwinds and tailwinds, the language of central banks is full of aviation metaphors. So it’s no surprise that the most heroic feat of policymakers is named after Apollo 11’s success in the space race. For experts, a “soft landing” occurs when the heat is taken away from an economy without tipping it into recession. However, the illustrious origin of the phrase hides a shameful reality. Such a landing was first predicted by U.S. Treasury Secretary George Shultz in 1973, but things didn’t go as planned. The recession began almost immediately; inflation ran rampant for the rest of the decade. Under the leadership of Federal Reserve Chairman Paul Volcker, prices finally cooled, but only after rising interest rates sent the U.S. into a back-to-back recession and the worst unemployment since World War II.
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While Mr Schultz’s predictions are wildly wrong, it’s not unusual. As Michael Kantrowitz of investment firm Piper Sandler points out, investors typically see a soft landing imminent as the Fed’s tightening cycle winds down. That’s exactly what happened this time. Since October, Second&p The Big 500 index rose 16%. A price index of investment-grade corporate bonds compiled by data provider Bloomberg rose 9%. Fears of a recession that were overwhelming just a few months ago now seem all but forgotten.
If history is any guide, such fears may well return. Not that a soft landing is impossible. Fed policymakers have managed them exactly twice since the 1970s. In 1984 and 1995, U.S. stocks rallied when interest rates peaked. Investors who bought in early reaped the rewards of a multi-year bull market.
But there have been six other tightening cycles over the past 50 years, all followed by recessions (even the sixth in 2019 was complicated by the covid-19 pandemic). One lesson is that soft landings are rare and hard landings are more likely. The more troubling lesson is that, early on, the two scenarios were indistinguishable based on how the stock market performed. Shares start to rise before each hard landing, sometimes for as long as a year. Then things started to go wrong. The economy falters, optimism fades, and the stock market plummets.
Mr Kantrowitz’s explanation for the similarities between the disparate scenarios is that, at least early on, a hard landing looks a lot like a soft landing. Both are characterized by rising interest rates, followed by rising stock prices as the market price turns for future rate cuts. For soft landings, that’s the end of the story. But for the hard-pressed, the worst is yet to come: employment is weak and housing and investors have been hit hard.
So today’s rising share prices are not an indication of whether the Fed’s current tightening cycle will come to a successful conclusion – opinions are widely divided on that. The more optimistic, chief among them U.S. President Joe Biden, pointed to an impressively resilient economy and a thriving labor market, despite the fastest string of rate hikes since the Volcker era. Others, however, worry that the impact of the rate hike is still to come. Edward Cole, asset manager at Man Group, worries that a tight labor market and a glut of household savings — both hangovers from the pandemic — are delaying the pain of monetary tightening that will eventually be felt. Average response of 71 professional economists surveyed in January wall street journalOne newspaper put the chance of a recession in the next 12 months at 61%.
If the stock market fails to provide adequate guidance, other indicators have more predictive power. Unfortunately, they present a less rosy picture. In previous Fed tightening cycles, soft landings have typically been preceded by relatively low inflation and accompanied by easier bank lending standards. The opposite is true today.
The most reliable recession indicator is the gap between the 10-year and three-month Treasury yields. Usually this is positive, with long-term yields higher than short-term yields (as investors demand higher returns to lock up their money for longer). Only nine times in the past half-century has this gap turned negative (meaning investors are anticipating imminent and ongoing rate cuts). Eight times later came a recession. The Ninth Negative Mantra started last October and continues until today. The most reliable part of the dashboard is flashing red as Fed officials bring the economy to the ground.■
Learn more from our financial markets columnist Buttonwood:
Soaring Stocks Ruin the Sacred Investing Rules (February 7)
The Last Breath of the Meme Era (February 2)
When Professional Stock Pickers Beat the Algorithms (January 26)
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