The most threatening thing for the market and economy is no doubt the upcoming rate hike. A rate hike per se is not something scary, but a series of actions can ultimately lead to recession. True, the yield curve is still steep based on the most predictive tenors 30-year or 10-year minus 3-month. Yet as the Fed hikes 50 or even 75 basis points every meeting, the front end of the curve will soon reach 2 percent to 3 percent or even higher. Even the inflation uptrend will continue to top up the backend, the bearish outlook might pose an opposite force rendering the curve to flatten and finally invert.
That says, inversion if any, will happen in the mid to late stage of a rate hike. Since inversion is predicting a recession in four to six quarters afterward, the time gap between the first rate hike and the start of a recession is longer than most expect. And because of this, a simple correlation computed between interest rate and stock index suggests they tend to commove. This is why there were numerous analyses saying rate hikes would never be worrying and the stock market would tend to be bullish. However, this time is different—different from many hike cycles.
We have not seen double-digit inflation in the United States for long, at least not in the past forty years. But we will see that again soon. The question is: Will such a speedy and aggressive hike lead to an earlier and prolonged recession? To see this visually, both Fed funds rate and recession periods (defined by the National Bureau of Economic Research) are charted together but the former leading the latter by two years. By phase shifting the two series this way, one should expect to see a rate hike period be overlapping with the recession period should the time gap be two years.
Looking back over the history of Fed funds rate changes, a recession did begin after two years of the first hike prior to 1974, the first oil crisis. Since then, however, recession lagged the first hike by more than two years. In a few cases such as the early 1960s and the mid-1990s, a series of hikes did not lead to any recession. Eyeballing the duration of these recessions, they seem to be longer and more frequent during the 1970s and 2008 financial tsunami. Conclusively, the mode of rate hike might alter the duration and frequency of recessions but not the timing.
Will the upcoming recession be lagging more than two years as were the cases of 2000, 2008, and 2020? Probably not. Recall the hikes before these recessions were on a measured pace. This time will be shock therapy thanks to the Fed being significantly behind the curve on inflation. Thus, the previous three should be regarded as abnormal cases that the Fed could manage well, whereas the normal cases are rate hikes in unplanned and probably uncontrolled manners. Unfortunately, yet certainly, we will encounter another normal case in this rate hike cycle.
In short, recession will likely kick start by the second half of 2023, where asset prices will begin reacting from the first half of 2023.
