Mike Dolan

LONDON (Reuters – You can avoid recession by tightening your belt now – this is what the Federal Reserve appears to have done almost thirty years ago.

The Fed increased its main rate by 6% within 12 months, starting in February 1994. This was achieved through seven quick-fire increases that comprised two moves of 50 basis points and an aggressive 75bp increase.

Although it hurt the bond markets and caused some to argue for more emerging market crises in the future, the Fed’s quick, sharp shock prevented an inversion on the 2-to-10 year Treasury yield curve. For many, this is the most reliable indicator of recession.

Due to the predictive power and flexibility of the yield curve, the U.S. was not in recession. However, the Fed achieved a rare soft landing for the economy.

With distortions due to a global pandemic, and an energy price shock caused by the war in Ukraine it is possible to see that history does not offer much guidance. Over the past three decades, much has happened in the banking system and bond markets.

It might be still useful for figuring out Fed’s response function.

“Eat Your Heart Out, 1994,” reckoned Morgan Stanley Weekend strategy by (NYSE:).

Last week, the U.S. central banking began its tightening cycle with a quarter-point rate increase from close to zero pandemic levels. However, with 40-year-high annual inflation rates nearing 8%, the central bank’s policymakers anticipated that rates would need to rise to so-called “restrictive” territory. This is in addition to what they consider a neutral 2.4% rate over the next two-years.

The markets scrambled to re-price this latest hawkish twist. Fed Chief Jerome Powell, on Monday, underlined the Fed’s new-found willingness to do whatever it takes to control inflation and said that the Fed will consider increasing the 50-bp rate if necessary.

Futures market participants now expect the Fed to add 200bp of tightening at its remaining six policy meeting of the year. They also plan on a “terminal” rate, which is a higher than expected, and that it will be near 3% next June, compared to a combined 2.5% and 9.0 by September 2023.

Fed watchers have also rushed to recalculate the magnitude of future Fed hikes. Goldman Sachs’ (NYSE:) economists anticipate two 50 bp rises each at their May and Juni meetings.

So far, so 1994. What about the yield curve?

After being crushed by 140 bp in the last year, and even though other areas of the curve have turned negative, the pivotal gap between the 2 and 10-year Treasury bond yields is still positive even though it’s currently teetering under 20 bps away from an inversion.

The record shows that the gap dropped to 7bp on December 1994 just after the massive 75bp Fed thunderbolt, but has never gone negative.

If the world markets continue to ring, it would seem that we are in for a long and nervy wait.

Graphic: Fed cycles, the yield curve and recessions: https://fingfx.thomsonreuters.com/gfx/mkt/gkplgqgkxvb/One.PNG

Graphic: What’s the Squeeze?: https://fingfx.thomsonreuters.com/gfx/mkt/gdpzyjyanvw/Two.PNG

NARROW “SOFT LANDING” STRIP

Deutsche Bank (DE:). Several others highlighted recently how tight the Fed’s’soft landing strip’ is. This shows how delicate it will be to touch down safely.

The Fed and markets agree now that policy rates must move at least half of the percentage point higher than the 2.4% rate estimate of neutral, intentionally cooling the economy to lower long-term potential growth of 1.8%. Inflation will then be dragged back to the 2-percent mark eventually.

Morgan Stanley’s team argues that it involves effectively cutting growth by half and then tapping and nudging control to slow momentum from pushing it over.

“Any such deceleration has to raise materially the probability of a recession, even if a recession is not the base case — which it is not for us,” it told clients.

According to the U.S. Bank, the 2-10 yield curve will invert this year – the U.S. ended the year with a negative 35bp but there is no recession.

Why? It cites the disappearance of “term premia” on longer-term bond yields over the last decade – an additional compensation investors used to demand to protect themselves from the possibility of something going wrong over many years of holding the same bond.

There are many reasons why this premium is disappearing. They range from the effects of Fed bond purchasing policies over years to the almost a decade-long sub-target inflation.

Today’s term premia do not allow for a normal inflation of the rate curve that maps the Fed’s actions to tighten, manage inflation, and then relax again. This could result in an inversion of the Treasury curve. It’s possible that the inversion is no longer what it once was.

A different view of the Fed could be that it is simply talking tough. The market panic will not force the Fed to take the aggressive steps seen in 1990s.

Kristina Holper, Invesco strategist thinks that the Fed might be warning her about how difficult it is to handle her rebellious teenage sons. Kristina says she likens it with trying to control them in vain.

Sometimes tough talk is the best thing.

The author serves as editor-atlarge at Reuters News for markets and finance. These views are solely his.

(by Mike Dolan. Tweet (NYSE:): @reutersMikeD