The disappointing GDP data yesterday further pushed down expectations for Fed rate rises for the remainder of this year. The first look at the second quarter showed another negative reading coming in at -0.9%, worse than the consensus estimate of a gain 0.4%, but not as bad as the first quarter contraction of -1.6%. The U.S. relies on the National Bureau of Economics to declare a recession but for many, the basic view of a recession is two consecutive quarters of contraction.
What everyone can agree upon is that the economy is slowing rather quickly, and that will keep the pressure on the Fed to tighten as much as they possibly can before they pause. With the 24% peak-to-trough correction, the S&P 500 may have already priced in the recession, and Federal funds futures implied the central bank’s main interest rate would average 3.26% in December, down from estimates of 3.32%.
Two weeks ago, estimates were at 3.69%, but weak economic data reports made market participants expect the Fed to take a more dovish policy. The S&P 500 may have bottomed on June 16th and has been grinding higher as federal funds rate expectations have fallen ever since. The 10-year Treasury yield, which moves with growth and inflation expectations, reached its lowest level since April at 2.68%, which suggests the duration risk of holding longer-date Treasuries is waning.
Investors and economists could make a solid case that stagflation is obviously here and will ultimately force the Fed into a difficult decision as to when they may need to pause tightening. The Fed will not see inflation below the terminal rate anytime soon, as inflation is still tracking well ahead of interest rates. If inflation is high but falling and unemployment is low but rising, the Fed will be in another bind. Regardless of how the economy or markets progress, the FOMC will need to see inflation falling on a consecutive basis before they pause or even reverse course.
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