By DNCA

Since 2022, increases in key rates and the inversion of the yield curve (respectively the steepest and longest in history) have set off recession alarms.

In Europe, it was narrowly avoided after Eurostat revised GDP upwards in the summer of 2023.

In the United States, it never seems to have seriously threatened to strike.

If the US economy has been so resilient to rate hikes, does this mean that the long-term neutral rate (R*) is higher than before?

It’s difficult to define the determinants of the neutral rate, which is considered theoretical. Economists generally cite productivity gains (which allow the economy to grow more, without overheating), inflation expectations or positive net migration as reasons for a higher rate. On the other hand, an aging population and declining birth rate justify a lower rate.

In any case, the question seems to be preoccupying the markets and dividing the members of the FED. For the first time since 2005, the Federal Open Market Committee’s (FOMC) decision to cut key rates by 50 basis points was not taken unanimously. Above all, the gap between FOMC members’ target rate projections is widening. In 2026, the hawks forecast 4%, the doves 2.4%. The median rate, higher than market expectations, has climbed since the last meeting…

For the time being, the risk they are most concerned about does not seem to be inflation, but the danger to the job market, and therefore to growth.

The job market will continue to be the main focus of attention. Because of the inertia of the labor market, unemployment figures take a long time to reflect the vagaries of the cycle. The data we have, and the light we see coming from the stars, are past information. Only time will tell whether the FED’s rate trajectory is in line with the economic reality facing the country.

For want of anything better to do, investors are turning to the past in an attempt to gauge return expectations following the FED’s first rate cut sequence. Historically, if not followed by a recession, the first rate cut bodes well for equities. In the case of a recession, however, the outlook is less rosy. Statistically, it’s when the yield curve disinverts that the countdown to recession and the end of the good times begins. In the week leading up to the FED’s decision, the spread between 10-year and 2-year bonds turned positive again. In almost 60% of cases, this preceded the US economy’s entry into recession by a year over the past 50 years…

The reading is complicated by the contradictory messages conveyed by the asset classes. Short-term interest rate futures reflect a more accommodative view than that of the FED. They favour a sharper economic slowdown than the soft-landing scenario favoured by equity markets, as evidenced by expectations of double-digit earnings growth in Europe and the USA. It’s hard to know which way to turn. As the third-quarter results approach, however, downward revisions seem to be getting underway, in the wake of earnings warnings such as Mercedes’. The return of decorrelation between bond and equity markets is excellent news for diversified management, but beware of the convergence of economic scenarios… Can we really count on widespread profitable growth while postulating a slowdown in the job market, growth and disinflation?

Text completed on September 20, 2024 by Thomas Planell, Manager – Analyst.

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