Soft Landing Narrative
April 19, 2023
Signs of easing banking sector stress has resulted in a return of the soft-landing narrative, higher bond yields and more hawkish Fed rhetoric. Although possible, an economic soft landing amid higher yields and further monetary tightening seems like an improbable outcome. A recession is the one sure way to control inflation. The idea that the Fed usually tightens policy until something breaks was evident in yesterday’s speech from St. Louis Fed President Bullard. In advocating for an additional 50bp of rate hikes, he said the labor market is currently too strong to credibly predict a recession occurring in H2’23 and added that the St. Louis Fed’s Financial Stress Index had reverted back to pre-crisis levels. Historically, the Fed has only ended a tightening campaign after achieving a positive real Fed funds rate. This requires the nominal Fed funds rate to exceed YoY core CPI. In today’s environment, that means an additional 50bp. A soft landing is improbable because CPI, non-farm payrolls and GDP operate with long lags.
Earnings and the multiples that investors are willing to pay for earnings growth determine stock prices. Higher interest rates and bond yields result in a higher cost of capital and lower earnings growth. Stocks usually rise in anticipation of increased earnings growth once bond yields peak. It’s fairly apparent that 10-year bond yields peaked back in early March, but the peak is still technically unconfirmed. In our opinion, a confirmed peak in 10-year nominal yields happens at levels below 3.20%. A confirmed peak in nominal bond yields would encourage a rotation into growth sectors. A confirmed peak in real yields would encourage rotation into Tech in particular. A peak in 10-year real yields would be confirmed at levels below +108bp. Nominal 10-year yields sit at 3.61% today and 10-year real yields are currently +132bp.
Major US equity indices are supported by record levels of sidelined cash, light positioning and nearly unanimous bearish sentiment. In the near-term, these factors reduce volatility and make equity markets more resilient than they would be otherwise. Low levels of implied equity volatility can give investors a false sense of security until an event causes a spike in volatility. The best recent example of this occurred in October 2018 when newly appointed Fed Chair Powell abruptly ended a predictable series of incremental 25bp rate hikes with a promise to hike rates ‘beyond neutral.’