September 2023 / GLOBAL FIXED INCOME
The Fairy Tale of a Soft Landing
The consensus view shift toward a mild downturn looks misplaced.
- A soft landing is merely a comfortable fairy tale, backfitted to match the prevailing market narrative and based on backward-looking unique circumstances.
- A hard landing is coming—it’s just a matter of when. The temporary benefits of looser financial conditions and U.S. fiscal spending will soon wear off.
- When global economic activity has been near current levels in past cycles, central banks were already cutting rates. But now they are still tightening.
Early in 2023, the consensus view was that a global recession was coming later in 2023. But as the year has matured, the consensus outlook has completely shifted. A soft landing—or even no landing—is now the consensus. What is remarkable is how strong the consensus has become. The consensus is, indeed, so consensus!
I think differently. A soft landing is merely a convenient and comfortable fairy tale, backfitted to match the market prevailing narrative and based on backward-looking unique circumstances. A hard landing is coming—it’s just a matter of when.
Likely One-Offs Provide False Hope
Europe’s warm winter allowed the region to avoid a deep recession, which was viewed as almost inevitable amid the high energy prices and supply problems following Russia’s invasion of Ukraine. This led to a burst of optimism about the region coming out of the winter. The European energy dynamic has surely improved, but probably not enough. Will we get another warm winter? I’m not sure investors should be allocating capital based on that hope.
On the fiscal side, U.S. growth received a boost from the Inflation Reduction Act1 in early 2023. It authorized almost $900 billion of total spending, mostly dedicated to manufacturing and climate change projects. The CHIPS and Science Act provided another fiscal tailwind to growth. While the fiscal impulse, or net stimulus from government spending, may still be positive, its power is waning. The upcoming U.S. election and the already large government deficit make a strong case that additional fiscal support will be limited.
Also, during the U.S. regional bank crisis in March, the Federal Reserve (Fed) stepped in to create a new term funding facility to ease the liquidity crunch at banks. Markets anticipated that the Fed would soon slow or stop its rate hikes, leading to a material loosening of financial conditions.2 The two-year U.S. Treasury note yield plunged to 3.77% on March 24 from 5.07% on March 8 as markets rapidly repriced their expectations for Fed tightening.3 Mortgage rates fell, providing another fleeting boost to the economy as yields and mortgage rates have now moved back up in response to the soft landing narrative.
Peak Everything: What Goes Up Must Come Down
But the temporary benefits of looser financial conditions and U.S. fiscal spending will soon wear off. In fact, I worry that we’ve reached “peak everything” in that all factors that have contributed to the global economy’s resilience have now turned.
- Peak fiscal
- Peak inflation
- Peak liquidity
- Peak China growth
- Peak housing
- Peak credit
- Peak employment
Aggressive Tightening, Leverage Set Stage for Hard Landing
It already appears that global manufacturing is flashing signals of being in a recession. The Covid-induced boom in the services sector is showing signs that it is also past the peak. Labor markets are not as strong as they were.
Most importantly, when global economic activity indicators were around current levels in past economic cycles, central banks were already well into rate-cutting mode. But this time around, we have central banks still tightening while also winding down their balance sheets through quantitative tightening. Global central bankers appear to have calibrated monetary policy to a world where the extreme tailwinds coming out of the pandemic—the spending boom driven by Covid-induced saving as well as the services-led recovery—continue well into the future.
The Fed has hiked the federal funds rate by more than 500 basis points (bp)4 since kicking off the tightening cycle in March 2022, and it currently looks like it could increase rates once more in 2023. The European Central Bank has tightened by over 400 bp and the Bank of England by more than 500 bp. Even the Bank of Japan, which has faced much lower inflation than in other developed markets, has widened its target range for government bond yields to let them increase.
As central bankers remind us, monetary policy works with long and variable lags. The cumulative global tightening is massive. This will eventually become the dominant narrative instead of the current market consensus’s focus on the warm glow of the recent one-offs.
Making matters worse, all the conditions for a hard landing are present. Leverage in pockets of the financial system seems to be rising, and we know from past experience that elevated leverage can quickly cause cracks to become craters. And we’ve already seen some cracks—regional bank liquidity problems in the U.S. as well as severe stresses in China’s property sector and UK pension funds. I fear that the next one may be a crater.
Leverage is now likely in different places than during the global financial crisis. We have seen large-scale disintermediation of the banking system into less well-regulated and more opaque areas. This just means that the vulnerabilities may play out in different areas than in the past.
Market Pricing in Soft Landing Is Unrealistic
The other area where leverage has increased is on government balance sheets. During Covid, there was a large scale transfer of leverage from the private sector to the public sector. This has a few consequences. First, fiscal balances are now largely tapped out. When the recession comes, it will be hard for governments to spend their way out.
Second, global governments need to sell a ton of new bonds. Recently, a lot of issuance has been in the Treasury bill market, but as we move into 2024, much of these bills will need to be termed out and replaced with longer-maturity debt.
Who will buy all this duration,5 especially at a time when central banks are stepping back from bond purchases? The implication is higher long-term bond yields. So while eventually central banks will respond belatedly to recession with rate cuts, there is the potential that the calming power of those official rate cuts may be offset by a lack of response in longer yields. A late, blunted, and incomplete response could lead to a deeper and longer malaise.
A soft landing is consensus. In the near term, China’s stimulus and potentially a build in inventories may prolong the good mood. But a hard landing is much more likely in the longer term. The only questions are when those long and variable monetary policy lags will show their inevitable dominance and how to navigate that journey.
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