MH Debate #2: No Recession, Higher Rates!

Summary

• US monetary policy (MP) does not look that restrictive, and financial conditions (FCs) are supporting labour market and economic growth.
• While the mistakes of the great inflation have been avoided, core inflation will struggle to return to target.
• The Fed and markets are still too optimistic about cuts.
• The election outcome could just mean higher budget deficit and more inflationary pressures.

Market Implications

• We are short 10Y and 30Y Treasuries.
• We also consider short SOFR December 2025 futures.

The Big Question

Can US rates go higher as the US economy avoids recession (and is not even slowing)?

Arguments in Favour

US MP does not look that restrictive in the current economic cycle. If it was, at the current FFR (Chart 1), the economy should not grow at around 3%. We made this point one year ago. It is still relevant and casts doubts about the validity of the real FFR as a measure to judge MP restrictiveness.

Chart 2 also suggests MP is not that restrictive, again keeping the odds of an imminent recession low. Let us be optimistic on core inflation ahead and take the parallel with the soft landing in 1995/96. Back then, the Fed managed to cut just 75bp. So why does this economy need another 150bp of cuts in the next year or so as per the latest SEP (on the top of the 50bp just delivered)?

FCs have been easing and remain very easy, and this will sustain growth and the labour market. However, they also tend to lead momentum in core inflation and suggest it will remain above target, preventing much Fed easing.

We see this in the Fed’s Financial Conditions Index (FCI), which aggregates changes in seven financial variables^[1] using weights implied by the FRB/US model and other models in use at the Federal Reserve Board (Chart 3 and 4).

Beyond the Fed’s FCI, not one case exists of the S&P 500 signalling such easy (and easing) financial conditions and the NFP still slowing into a recession (Chart 5).

The hires rate has dropped, but this does not necessitate a much higher unemployment rate (UR). Hiring is slowing and, all else fixed, this puts upward pressure on the UR. Indeed, in the past, at this level of hires rate, the UR was higher (Chart 6). Yet all these facts do not necessarily mean hiring will keep falling and the UR will rise materially. Labour demand is much higher vs supply this time. It is falling, but this seems more a normalisation than a collapse (Chart 7).

The rise in the UR in the last 1.5 years has been mainly due to an increase in the labour force. Meanwhile, layoffs and initial jobless claims have remained generally contained. Given labour supply growth is slowing (Chart 8), unless initial jobless claims materially increase, the UR should keep levelling off in the next few months. This is the first time in the last 60 years that a rise in UR has not come with a leading/ contemporaneous increase in jobless claims (Chart 9).

While a red sweep will very likely boost budget deficit and inflation, a blue sweep could also prove more inflationary as the Democrats have also promised to keep spending.

Arguments Against

MP is restrictive. The proof is that inflation has dropped considerably in the last 2.5 years while core inflation remains in a downtrend. The pick-up in core CPI in September was mainly driven by components that are very often volatile and have much less influence on core PCE, which is the Fed’s preferred measure. This will likely prove to be just a one-off pick-up in core inflation.

The outlook for core inflation remains very encouraging: core goods inflation remains extremely benign. While shipping costs are elevated, they are well below July’s peak, and the strikes ended quickly. Given restrictive MP, consumer demand is due to fall. This means wholesalers’ and retailers’ gross margins will probably decline. Leading indicators of wage growth like quits indicate much more moderation, which will put downward pressure on core services inflation excluding housing. Also, housing inflation is due to slowdown more. Oil price has increased but remains low.

During the great inflation from the second half of the ’60s to the beginning of the ’80s, the Fed eased policy a few times before inflation slowed substantially. This is not the case today. The Fed is easing with inflation just modestly above target.

One-off factors like hurricanes and strikes are likely to affect the next jobs report, while seasonality boosted the last one. One very strong report does not make a trend. And while the hiring rate does not pick up and trend sustainably higher, it is hard to argue the economy will continue to grow above potential and recession risks remain non-negligible (essentially Claudia Sahm’s argument).

Indeed, many other labour market indicators have weakened substantially (jobs opening rates, quits rates, Conference Board Labor Differential, Regional Fed employment surveys, temporary help services on payrolls, permanent job losers, and employment breadth to mention a few). The slowdown in hiring is important because it signals companies are having difficult times. Housing and manufacturing continue to disappoint as MP is still too restrictive.

A divided Congress could struggle to deliver enough fiscal stimulus increasing the probability of a recession.

Our View

• We think that MP is not sufficiently restrictive, and FCs are too loose.
• We also think US yields have more room to rise given the economy remains strong and core inflation will struggle to return to target.
• We think a recession can happen, but only if a substantial tightening of FCs happens first.
• We also think that a soft landing in a 1995/96 style is possible but less likely than a recession at the end of this cycle.

How to Trade This View

• We are short the US 10Y and 30Y and considering short SOFR December 2025 futures on a rally.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)

1. The FFR, the 10Y UST yield, 30Y fixed mortgage rate, the triple-B corporate bond yield, the Dow Jones total stock market index, the Zillow house price index, and the nominal broad dollar index. ↑