The risk of the America slipping into recession is 'material and rising'
- Wall Street volatility has spiked amid renewed uncertainty over the pace of Federal Reserve interest rates hikes.
- "We do not forecast a recession as our base case, but we believe the risk is material and rising," UBS economists write in a research note.
- The market's fear centers around the risk the Fed will tighten monetary policy too quickly in response to tax cuts delivered at a time of low overall unemployment.
There's a key reason financial markets have suddenly become unsettled: the fear tax cuts could generate the kind of inflation that might force the Federal Reserve to raise interest rates more aggressively.
Put differently, investors are signaling they believe risk of a policy error from the Fed that tips the economy into recession has risen sharply, in part because of the poorly-timed fiscal stimulus, which comes as the jobless rate is already at a 17-year low of 4.1%.
"The risk of a hard landing has risen notably," wrote Seth Carpenter, a former Fed economist, and the UBS economics group he leads.
"The Fed began raising rates in 2015-long before there were hints of any inflation- to avoid an abrupt slowing in the economy that would risk a recession. We believe the additional fiscal impetus will make the Fed's actions less gradual."
Because of this, UBS concludes: "We do not forecast a recession as our base case, but we believe the risk is material and rising."
One major problem that arises from such concerns is that they may be self-fulfilling. The market's inflation fears first expressed themselves in a rise in long-term bond yields, which in turn spooked stock investors.
Investors shifted from doubting the Fed's resolve to raise interest rates three times this year to believing it will likely tighten policy four times in 2018.
The Fed has raised its benchmark federal funds rate five times since December 2015 to its current range between 1.25% and 1.5%, having left it at zero for seven years before that in response to the Great Recession and its aftermath.
In the process, the Fed also more than quintupled its balance sheet in three rounds of "large-scale" Treasury and mortgage purchases that became known as quantitative easing or QE.
Now, as the Treasury ramps up debt issuance because of the new stimulus and massive budget deficits, the Fed is not only tightening monetary policy but also shrinking its balance sheet by reducing its own bond holdings, putting upward pressure on borrowing costs.
"Higher deficits, tighter financial conditions, and an accelerating pace of rate hikes will be a difficult combination for financial markets which have grown used to low and stable growth," Credit Suisse market strategists wrote in a research note. "We now expect the Fed to hike rates four times this year (our previous forecast assumed they would pause in Q4)."
They add that "macro volatility is likely to pick up and the risk of a large negative shock is increasing. We are optimistic about near-term growth, but it is becoming easier to envision the end of the current, near -decade long economic expansion."
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