May 16, 2023 | By Hank Cunningham
Global growth prospects have deteriorated, with the IMF downgrading its outlook but still with a positive estimate. In light of recent developments in the banking industry, the global economy will be fragile. Recession forecasts are growing, and some are concerned about a possible bout of credit contraction.
Nevertheless, it would be naïve to think that the U.S. Federal Reserve will lower the Fed Funds Rate any time soon. The Fed may pause, as it considers the cumulative effects of the tightening to date, and it will be more keenly attentive to economic data. However, the fallout from the regional banking crisis is causing a credit contraction, which, if it accelerates, could cause economic activity to slow more rapidly than current consensus. At minimum, the Fed would have to pause here. At worst, it may have to relax its monetary tightness and begin lowering rates. To be sure, there are cracks showing in the taut labour market, consumer confidence is ebbing and manufacturing has weakened significantly.
On a global scale, there are few signs of inflation subsiding sufficiently to allow central banks to contemplate easing monetary policy. For inflation to reach 3% seems optimistic.
Thus, central banks will likely retain their restrictive stances for the balance of the year; inflation will remain the overriding concern and with some recent setbacks in core inflation, both in North America and overseas, it is possible that bond yields could move back up. However, it is more likely that the 10-year yield will continue to fluctuate in a range centered around 3.50%.
Consumer confidence has been dealt a huge blow, which may contribute to a meaningful near-term contraction in economic activity. Already, retail sales have declined markedly. Fed tightening over the past 14 months is working its way through the system and the recent liquidity calamity is evidence that tightening is straining the U.S. economy. Once this passes, and it will, market participants will re-focus on inflation, the economy and the Federal Reserve.
The yield curve will stay inverted for a while, but it has normalized meaningfully of late. With two-year and 10-year Treasurys seemingly anchored at 4% and 3.5% respectively, there is little room for these bond yields to decline. In the meantime, fixed income investors, having already earned a 3.65% average return thus far this year, can look forward to an additional 2% to 3% return for the balance of the year. A typical one- to five-year ladder offers a yield to maturity of almost 5% and has a short duration of just over two years.