What Should We Expect After the FOMC Pauses Next Week?

The Federal Open Market Committee (FOMC) concludes its next scheduled meeting on June 14th. As evidenced in the table below, Fed Funds Futures are currently calling for the FOMC to pause its rate-hiking campaign at next week’s meeting leaving rates at 5.00% - 5.25%. This comes after 10 consecutive meetings where the FOMC has raised rates by a cumulative total of 500 basis points (bps).

While subject to change, Fed Fund Futures are also signaling that the FOMC will raise rates six weeks later at the conclusion of the July 26th meeting and subsequently begin an “easing campaign” with the conclusion of the November 1st meeting.

The US economy is extremely dynamic and resilient; therefore, suggesting that rate hikes, pauses, or eases will play out exactly as outlined above is a fairly low probability outcome.

Instead of trying to predict where the Fed Funds rate will be a year from now, we are going to focus in this piece on what is likely to happen next (i.e., a “pause”) and what a “pause” typically means for the US economy and various asset prices.

The Typical Cycle

At a very high level, the US economy typically goes through a repeatable cycle consisting of the following stages: Expansion, Peak, Recession, and Recovery. In support of its “dual mandate”, this tends to create a repeatable cycle with regard to how the FOMC responds to these various stages of the US economy.

Expansions are typically met by an FOMC that is forced to raise rates to cool inflation. This tends to lead to a market peak and ultimately a recession. Recessions are typically met by an FOMC that is forced to reduce rates to spur the economy. This tends to lead to a recovery followed by an expansion. In between the periods when the FOMC is actively working to stimulate or cool the economy, interest rates typically remain stable or “paused” and then the whole cycle starts over again.

Where Are We Today?

The FOMC began a rate hiking campaign in March 2022. This tells us that the US economic expansion had reached a point where the FOMC was concerned enough about inflation that they needed to take steps to cool the US economy with the hopes of subsequently bringing down inflation.

We can infer from this that the US economy is likely in the process of peaking or has already peaked and that it is heading directionally toward a recession. No one ever rings a bell to signal that we have moved from one stage to the next so the best we can do is to infer our current location by looking at FOMC activity, current/projected US economic growth, asset prices, etc.

FOMC Activity

If we start by focusing on the current FOMC activity, we find that we are currently in the midst of a rate-hiking campaign. There have been six rate hiking campaigns (including the current one) since the mid-1980s as I have detailed and highlighted in the chart below.

During the current rate hiking campaign, the FOMC has raised rates by the largest amount, 500 basis points in total (which would increase with a July rate increase), and at the fastest pace, an average of 37 basis points per month, in over 40 years.

For context, the previous largest cumulative rate hiking campaign was 425 basis points in total (2004), and the previous fastest pace rate hiking campaign was approximately 25 basis points per month (both 1988 and 1994). This current rate hiking campaign is larger and more aggressive than anything we have seen in the last 40 years.

Current/Projected US Economic Growth

US GDP remains positive but has been declining for several quarters. GDP figures are always backward looking so I prefer to look at leading economic indicators.

The chart below shows the most recent release of The Conference Board’s Leading Economic Index (LEI). Note that not only has the “Warning Signal” been triggered, but the “Recession Signal” has also been triggered.

Further, note what The Conference Board said in its press release regarding its latest figures:

“The LEI for the US declined for the thirteenth consecutive month in April, signaling a worsening economic outlook,”

“Weaknesses among underlying components were widespread—but less so than in March’s reading, which resulted in a smaller decline.”

“Importantly, the LEI continues to warn of an economic downturn this year.”

For a more extensive look at LEI and the Philly Fed, feel free to check out a piece I wrote earlier this year on this topic by clicking here.

Asset Prices

An economy in recovery or expansion tends to see major commodity prices (i.e., copper, crude oil, gasoline, lumber, etc.) or major stores of wealth (i.e., real estate) in an upward trend similar to the period in the chart below just after the recession of 2020. Instead, what we’re currently seeing are major commodities, real estate, etc. that peaked somewhere in 2022 and have steadily been trending lower. This is typically not indicative of a recovery or an expansion.

Yes, you can argue that the S&P 500, and some sectors, namely Technology, are currently defying logic with their YTD gains, but my sense is that has more to do with the technicalities of recent liquidity in the system vs. a front-running of future economic growth.

If the following chart plays out, we could see the S&P 500 “catch down” to what the charts above are suggesting with regard to US economic growth.

Putting it All Together

FOMC activity, current/projected US economic growth, and asset prices appear to be suggesting that the US economy is in the process of peaking or has already peaked and is heading directionally toward a recession.

Only time will tell if the US officially moves into a recession; however, history shows us that four of the last five (or 80% of the time) rate hiking campaigns ended in a recession.  You can look at this 80% figure in two ways: 1) things that happen 80% of the time are probably likely to happen again or 2) it has happened so often historically that we’re overdue for the opposite outcome (i.e., avoiding a recession).  I have no idea which one will come true this time, nor does anyone else.

What to Expect Going Forward

The FOMC typically pauses for a period of time following a rate hiking campaign. Looking at the five previous rate hiking campaigns, the shortest pause was just over a month (33 days), while the longest pause was almost 15 months (446 days). The average pause is just over 7 months (218 days).

During the “pause” period, the delayed impact of the rate hiking campaign has time to filter through the economy which, as prescribed, slows economic activity. This slowing of economic activity typically leads to a recession and forces the FOMC to initiate an easing campaign in order to support the economy.

Watch US Treasuries

Once the easing campaign begins, US Treasuries tend to rally (i.e. prices increase, yields fall). In the chart below, I am showing the Fed Funds target rate plus the yield on various durations of US Treasury bonds.  I highlighted the one occurrence where we did not have a recession following a rate hiking campaign to show that even though we didn’t have a recession, US Treasury yields still fell in tandem with a decrease in the Fed Funds rate.

Conclusion

Several of the asset classes I noted above (i.e., copper, crude oil, gasoline, lumber, real estate, etc.) have peaked for this cycle and have declined fairly substantially. However, US Treasuries yields have yet to decline by the same order of magnitude but I believe this will happen once the FOMC begins its next easing campaign.

For context, you can see in the chart above that four of the five previous rate-hiking campaigns ended in a recession, and in every one of those cases, except where bound by the 0% floor, the “new low” in interest rates was lower than the previous low. This tells me that if the US finds itself in a recession, there is a very high chance that the FOMC will end up taking interest rates back to 0% thus creating a massive rally in US Treasury bonds.