Policy

The growing threat of fiscal dominance; lower real interest rates; a weaker USD; increasing aggregate demand in Asia spurred by Chinese stimulus; safe-have demand driven by growing war risk all are bullish for gold. We are lifting our price target to $2,000/oz by year-end (from $1,900/oz) and upgrading our recommendation to a strategic holding.

Highlights Market expectations for Fed rate cuts later this year reflect either an extremely mild US recession, or a nonrecessionary scenario in which inflation falls rapidly back toward the Fed’s target. In the case of a true recession, even a historically mild one, the Fed will likely cut interest rates meaningfully below what is priced into the OIS curve – to 1% or lower. It is plausible that the Fed could ease monetary policy this year before the US economy begins to contract, because the Fed wrongly believes that the neutral rate of interest is just 2.5% – well below the current policy rate. Monetary policy rules also point to interest rate cuts even if the Fed’s current inflation and unemployment rate forecasts for this year come to fruition. However, several conditions would need to be met for the Fed to consider easing monetary policy, meaning that the prospect of nonrecessionary rate cuts this year is possible but not especially likely. Given that US monetary policy is currently tight, a high bar for the Fed to cut rates supports a defensive stance. Investors should remain underweight stocks versus bonds in a multi-asset portfolio over the coming 6-12 months. Feature Chart II-1The Market Expects The Fed To Cut Interest Rates In The Second Half Of The Year The Market Expects The Fed To Cut Interest Rates In The Second Half Of The Year The Market Expects The Fed To Cut Interest Rates In The Second Half Of The Year Based on the shape of the OIS curve, investors are projecting that the Fed will cut interest rates in the latter half of this year. Chart II-1 highlights that the OIS curve peaks at 4.9% as of this summer, falling to 4% by the end of this year. The common interpretation of this is that the OIS curve reflects investors’ expectations of a mild recession. However, an alternative explanation is that financial markets are priced for a soft-landing scenario, in which the Fed cuts rates back toward its neutral rate estimate in response to declining inflation before the US economy tips into a recession. In this report, we explore what it will take for the Fed to cut interest rates in both a recession and non-recession scenario for this year. In the case of a true recession, the Fed will not only cut the fed funds rate, they are also very likely to cut it meaningfully below what is priced into the OIS curve – to 1% or lower. And, while it is plausible that the Fed could ease monetary policy this year before the US economy begins to contract, it does not seem particularly likely, given that several conditions would need to be met. For now, our conclusions continue to support a defensive stance, arguing that investors should remain underweight stocks versus bonds in a multi-asset portfolio. Fed Rate Cuts: The Recession Scenario The most obvious scenario in which the Fed cuts interest rates is one in which the US economy slips into a recession, which we believe is more likely than not to occur at some point over the coming year. Chart II-2 highlights that the Fed has always eased monetary policy following the onset of recession in the post World War II (WWII) environment. Many investors would argue that the recession scenario is effectively what is being priced into financial markets: 12-month forward earnings have modestly declined, consensus economic forecasts call for at least one quarter of negative growth in 2023 and a rise in the unemployment rate to 4.8%, and the OIS curve is now pricing in 225 basis points of interest rate cuts from Q2 2023 to Q2 2024 (Chart II-3). Chart II-2The Fed Would Certainly Ease Monetary Policy Were A Recession To Occur The Fed Would Certainly Ease Monetary Policy Were A Recession To Occur The Fed Would Certainly Ease Monetary Policy Were A Recession To Occur Chart II-3Consensus Economic Forecasts Call For An Extremely Mild Recession This Year Consensus Economic Forecasts Call For An Extremely Mild Recession This Year Consensus Economic Forecasts Call For An Extremely Mild Recession This Year   As such, some argue that, based on these apparent expectations of a very mild recession, earnings are not likely to decline significantly from current levels and the equity market has already priced in upcoming economic weakness. Effectively, the consensus view is pricing in what the Fed is projecting in its most recent Summary of Economic Projections. We think that is not a likely occurrence for the following reasons: Following WWII, the US unemployment rate has never risen less than 2% during a recession (Chart II-4). What the market is calling a “mild recession” would actually be the mildest recession in US history, by a nontrivial amount. Peak-to-trough declines in earnings during recessions are typically between 10-20% (Chart II-5), versus the 3-4% decline that has occurred over the past year. And while it is true that 12-month forward EPS only recorded a single-digit decline during the 1990-91 recession, that decline occurred against the backdrop of meaningfully lower profit margins compared to the present day; there was thus less of a risk to earnings at that time from margin compression. Chart II-4The Market's Small Expected Rise In The Unemployment Rate Has Never Occurred In Post-War US History The Market's Small Expected Rise In The Unemployment Rate Has Never Occurred In Post-War US History The Market's Small Expected Rise In The Unemployment Rate Has Never Occurred In Post-War US History Chart II-5US Earnings Per Share Do Not Reflect A Recession US Earnings Per Share Do Not Reflect A Recession US Earnings Per Share Do Not Reflect A Recession       The equity risk premium has fallen, rather than having risen, as monetary policy has become tight (Chart II-6). Within the bond market, the level of interest rates priced into the OIS curve following the onset of rate cuts is very likely too high for a recession scenario. 1-year/1-year forward bond yields currently trade at roughly 3.7%, which is barely stimulative based on our view of the neutral rate of interest and still tight based on the Fed’s neutral rate view as well as the market’s. As we wrote in our September Special Report,1 the historical experience of recessions suggests that the Fed will cut the policy rate close to the zero lower bound (Chart II-7). That is based on the historical level of interest rates relative to potential growth or average realized nominal GDP growth. It is possible that the Fed will cut rates closer to 1%, but we suspect that this would most likely only occur in a scenario wherein core inflation was slower to return to target levels than the Fed expects. Absent another supply-side shock over the coming 12-18 months, we believe that the combined effect of waning pandemic-related and supply-side driven inflation, decelerating house prices and rental rates, and weak aggregate demand in the case of a recession is more likely than not to bring core inflation back to, or even below, target levels. Chart II-6The US Equity Risk Premium Is Too Low Given Recessionary Risks The US Equity Risk Premium Is Too Low Given Recessionary Risks The US Equity Risk Premium Is Too Low Given Recessionary Risks Chart II-7The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory February 2023 February 2023 The historical experience of Fed rate cuts during recessions shown in Chart II-7 is also supported by two monetary policy rules when considering the Fed’s current neutral rate assumption. Chart II-8Monetary Policy Rules Suggest The Fed Funds Rate Will Fall To Between 0-1% In A Recession Monetary Policy Rules Suggest The Fed Funds Rate Will Fall To Between 0-1% In A Recession Monetary Policy Rules Suggest The Fed Funds Rate Will Fall To Between 0-1% In A Recession The most well-known monetary policy rule is the Taylor Rule, but FOMC officials have more commonly spoken about another rule called the balanced-approach rule with shortfalls (which is, itself, a version of the original Taylor Rule). In this version of the rule, the policy rate is equal to the Fed’s inflation target, plus the real neutral rate of interest, plus the inflation gap (times a multiplier), plus the output gap when the gap is negative. This one-sided consideration of the output gap is somewhat compensated for by an inflation gap multiplier that is larger than 1 (typically 1.5, versus 0.5 in the Taylor Rule). In short, compared to Taylor Rule, the balanced-approach with shortfalls rule will produce a policy rate that is the same as that produced by the Taylor Rule for any given level of inflation when the unemployment rate is at NAIRU, but less than the Taylor Rule as the unemployment rate deviates from NAIRU in either direction. As such, the balanced-approach rule with shortfalls is a strictly more dovish monetary policy rule than the Taylor Rule. Assuming a recession scenario in which core PCE inflation falls to 2% and the unemployment rate rises to 5.5%, the balanced-approach rule projects a -0.5% policy rate (Chart II-8). Using the same assumptions for the Taylor Rule and deriving the output gap through Okun’s law, the policy rate is projected to be 1%. A simple average of these two approaches is 0.25%, which is effectively the Fed’s lower bound. This underscores that investors should shift heavily into a long duration stance in response to concrete signs that the US economy is indeed veering into recession, which we expect to become evident in the labor market over the coming few months. Fed Rate Cuts: The Nonrecessionary Scenario As noted above, the view of most investors is that financial markets are pricing in the likelihood of a US recession, and that the OIS curve reflects what investors believe is the likely recessionary interest rate path. Chart II-9According To The Fed's Neutral Rate View, Monetary Policy Is Already Extraordinarily Tight According To The Fed's Neutral Rate View, Monetary Policy Is Already Extraordinarily Tight According To The Fed's Neutral Rate View, Monetary Policy Is Already Extraordinarily Tight Another possibility is that investors expect nonrecessionary rate cuts, as the Fed responds to easing inflation by lowering the policy rate closer to its estimate of neutral – what the Fed and many investors refer to as a “soft landing”. That would still be consistent with our interpretation of the yield curve that we noted in Section 1 of our report, and the muted decline in 12-month forward S&P 500 EPS. The core basis for the nonrecessionary rate cut view is the fact that the Fed believes the neutral rate of interest is just 2.5%, which is well below the current policy rate (Chart II-9). In fact, as we have highlighted in past reports, monetary policy is the tightest it has been since the 1980s based on the Fed’s neutral rate view. We strongly disagree with the Fed’s estimate of the neutral rate. But from a strategy standpoint, it is important to predict how the Fed will act, rather than how it should act. Unless the Fed revises its neutral rate estimate higher, it is possible that they will choose to lower interest rates before a recession has begun, in response to an “immaculate disinflation” scenario in which inflation decelerates rapidly back toward its target. The key question is how low inflation would need to fall before the Fed becomes comfortable easing policy. Charts II-10 and II-11 highlight what the balanced-approach with shortfalls rule would imply in view of the Fed’s most recent forecasts from the summary of economic projections, as well as in a true soft landing scenario wherein the unemployment rate rises to just 4% and inflation returns completely back to the Fed’s 2% target. In the first case, the balanced approach rule prescribes a policy rate of 3.6%, close to 160 basis points below what the Fed’s policy rate projection for the end of this year. In the second case, given a closed inflation gap and an unemployment rate at NAIRU, the rule prescribes a policy rate that is in line with the Fed’s neutral rate estimate of 2.5%, approximately 260 basis points below what the Fed projects for this year. Even the Taylor Rule would point to rate cuts in both scenarios, projecting a policy rate of 4.1% and 2.5%, respectively. Charts II-10 and II-11 make it clear that the Fed has stated plans to maintain very high policy rates compared to what typical monetary policy rules would advise. Why is this the case? There are three possible answers. Chart II-10Monetary Policy Rules Prescribe Lower Interest Rates Than The Fed Is Forecasting Given The Fed’s Economic Forecasts Monetary Policy Rules Prescribe Lower Interest Rates Than The Fed Is Forecasting Given The Fed's Economic Forecasts Monetary Policy Rules Prescribe Lower Interest Rates Than The Fed Is Forecasting Given The Fed's Economic Forecasts Chart II-11A True Soft Landing Scenario Would Imply Significantly Lower Interest Rates, Given The Fed’s Neutral Rate View A True Soft Landing Scenario Would Imply Significantly Lower Interest Rates, Given The Fed's Neutral Rate View A True Soft Landing Scenario Would Imply Significantly Lower Interest Rates, Given The Fed's Neutral Rate View     The first is simply that monetary policy rules are not part of the Fed’s reaction function and have no bearing on monetary policy. This is possible, but not a particularly likely explanation given that Fed officials occasionally refer to them and that they are structured in a way that at least theoretically captures the Fed’s reaction function. The second possible answer is related to the fact that the fed funds rate significantly undershot what monetary policy rules would have prescribed in 2021. It may be that the Fed is attempting to compensate for this deficit when setting interest rates over the coming year, especially given how significantly some measures of inflation expectations have risen. In fact, this perspective is theoretically supported by the idea of the modern-day Phillips Curve. We noted in our January 2021 report that if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero.2 Given that the output/jobs gap is fundamentally determined by the stance of monetary policy, the Fed may see its failure to raise rates in 2021 as having contributed to too long a period of very strong employment, which needs to be balanced by a period of “too-high” interest rates. Chart II-12There Is Good Evidence So Far That Long-Term Inflation Expectations Are Forward Looking There Is Good Evidence So Far That Long-Term Inflation Expectations Are Forward Looking There Is Good Evidence So Far That Long-Term Inflation Expectations Are Forward Looking Additionally, recent work from the IMF on the risk of a wage-price spiral has shown that the magnitude of the monetary policy response required to prevent such a spiral is determined by whether long-term inflation expectations are primarily backward or forward looking.3 Chart II-12 provides good evidence that long-term inflation expectations have recently been forward looking, but the Fed may believe (reasonably so) that this is less likely to be true the longer that inflation remains above its target level. Finally, the third possible answer explaining why the Fed’s rate projections this year are so much higher than monetary policy rules would prescribe is that the Fed is simply jawboning. The goal of jawboning the market would be to convince economic agents to set lower prices and accept lower wage growth to ensure that inflation does indeed return to target, such that the Fed either does not actually need to raise short-term interest rates to the level they are projecting, or must quickly lower them once their unemployment rate and core PCE inflation projections materialize. As we noted in Section 1 of our report, we do not think that the latter scenario is likely. However, if it does occur, it could enable the US economy to avoid a recession in 2023, and would likely alter our current asset allocation recommendations in the direction of increasing risky asset exposure on a 6-12 month time horizon. R-Star Wars? Chart II-13The Secular Stagnation Narrative Is Now, Wrongly, Embedded In The Fed's Thinking The Secular Stagnation Narrative Is Now, Wrongly, Embedded In The Fed's Thinking The Secular Stagnation Narrative Is Now, Wrongly, Embedded In The Fed's Thinking As noted above, the core basis for a nonrecessionary rate cut view is the fact that the Fed (wrongly) believes the neutral rate of interest is meaningfully below the potential rate of nominal economic growth. This view has been heavily influenced by the revival of the theory of secular stagnation by Larry Summers in the fall of 2013 (Chart II-13). Thus, the expectation of some investors that the Fed will ease monetary policy before a recession begins will be undercut if the Fed were to raise its expectations for the neutral rate, or were to act as if it believed that R-star might be higher, even if those beliefs were not reflected in the FOMC’s Summary of Economic Projections. While the Fed has made no indication that this is the case, recent comments from Summers himself during a recent interview suggest that the Fed’s longer-run interest rate projections may increasingly come under pressure: “The thirty-year story has been declining interest rates and the idea that we're moving into an era of low interest rates. That was certainly the thesis that I was pushing with the idea of secular stagnation prior to COVID; that has been the basis for a large amount of economic thinking. The idea that we are going to return to [that environment] is a kind of orthodoxy baked into markets. You see it when the Fed predicts a half a percent neutral real rate, you see it in breakevens on inflation in the low 2s, you see it in a 10-year rate in the 3.7% range. And that might be how things play out. The forces of secular stagnation – demography, inequality, lower priced capital goods – all of that are strong. But my guess is that just as those who during the Second World War predicted that when the war ended we would return to secular stagnation and a sluggish low interest rate economy turned out to be wrong, that is going to be true this time around. I think we are in a new era of much higher government debt ratios. We are in an era, including because of national security spending, of substantially larger budget deficits. We are in an era of much higher investment demand because of resilience investment and reshoring, and because of green energy transformations that are going to happen all over the world. At the same time, the disinflationary shock of billions of people in emerging markets joining the global labor pool and applying disinflationary pressure – that is surely not going to continue at the same rate [as over] the last several decades. And it may, given developments in China, actually go into reverse. There is going to be [an increase] in uncertainty and I think [that is] likely to translate into increased term premiums. So my guess is that this is going to be remembered as a “V” year, when we recognized that we were headed into a different kind of financial era with different kinds of interest rate patterns.” Larry Summers, Bloomberg TV, January 6, 2023 Some of Summers’s comments relate to the belief that nominal interest rates will be higher in the future because of structurally elevated inflation, but some of what he expects would relate to a higher real neutral rate, particularly the idea that global investment demand will be stronger because of increased defense spending, resilience investment / reshoring, and green energy projects. A broader discussion of whether the factors that Summers raised are likely to materialize will likely be the subject of future BCA Research reports. But for now, the key point is that the idea of a low neutral rate of interest may become increasingly controversial over the coming months and years, implying that investors cannot necessarily rely on the Fed’s low neutral rate view to act as a strong basis for significant rate cuts over the coming year outside of the context of a recession, even if inflation slows significantly. Investment Conclusions We noted above that there are two scenarios in which the Fed could cut interest rates over the coming year. The first scenario involves a recession, which we think is the most likely economic outcome over the coming year. However, were a recession to occur, it is likely to be more severe than investors currently expect, because what the market is calling a “mild recession” would actually be the mildest recession in US history, by a nontrivial amount. Based on the historical experience of recessionary interest rate cuts, as well as what is implied by monetary policy rules, we expect the Fed to cut the fed funds rate to 1% or lower in a recessionary scenario. This underscores that investors should shift heavily into a long duration stance in response to concrete signs that the US economy is indeed veering into recession, which we expect to become evident in the labor market over the coming few months. The second rate cut scenario involves the Fed easing monetary policy before the economy veers into contractionary territory. This is a plausible scenario given that the Fed believes the neutral rate of interest is just 2.5%, meaning that the current stance of monetary policy is extremely tight according to the Fed’s view. Monetary policy rules point to interest rate cuts even if the Fed’s current inflation and unemployment rate forecasts for this year come to fruition. The latter underscores that the Fed could cut interest rates this year in a nonrecessionary context if all of the following conditions are met / become true: Core PCE inflation falls below the Fed’s 2023 forecast of 3.5% Inflation expectations remain well anchored or decline from current levels The Fed does not believe that it needs to compensate for “too-low” interest rates in 2021 with a period of “too-high” interest rates The Fed does not upwardly revise its real neutral rate view or set monetary policy as if R-star were higher than the FOMC currently projects Were this nonrecessionary rate cut scenario to materialize, it would likely cause us to change the investment recommendations that we outlined in our 2023 Annual Outlook. Evidence that the Fed is shifting toward rate cuts prior to the onset of a recession would still cause us to recommend a long duration stance (as the Fed would be lowering short-term interest rates), but we would likely recommend increasing exposure to risky assets back to overweight. Falling long-maturity bond yields would support equity multiples, and the avoidance of a recession would almost certainly point to positive earnings growth, the combination of which would likely lead stocks to outperform bonds over a 6-12 month time horizon. For now, however, we do not find the prospect of nonrecessionary rate cuts to be especially likely, meaning that interest rates are likely to fall later this year because of a recession rather than in the context of a “soft landing”. This supports a defensive stance, indicating that investors should remain underweight stocks versus bonds in a multi-asset portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst “The Fed Funds Rate, Bond Yields, And The Next US Recession,” dated August 25, 2022, available at bca.bcaresearch.com 2  Please see The Bank Credit Analyst “The Modern-Day Phillips Curve, Future Inflation, And What To Do About It,” dated December, 2020, available at bca.bcaresearch.com 3  “Wage Dynamics Post–COVID-19 and Wage-Price Spiral Risks,” International Monetary Fund World Economic Outlook, October 2022

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