An End to Rate Hikes May Not Be Enough to Prevent an Economic Downturn

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Equities finished the week lower as bond yields rose, and investors interpreted comments from Federal Reserve Chairman Jerome Powell as a signal that rates will need to stay higher for longer to bring inflation back to the Fed’s 2 percent target. To be sure, Powell offered some solace to investors by suggesting that rising bond yields may negate the need for additional rate hikes for the remainder of the year. However, recent data (such as last week’s strong retail sales report) suggests that consumers are still in a buying mood, likely thanks to still elevated wage growth. As we’ve noted in past commentaries, while the pace of wage growth has slowed in recent months, it’ still too high and likely incompatible with bringing inflation down to 2 percent.

The fact that the Fed appears to be willing to hold rates steady for the rest of the year is encouraging and likely reflects its recognition that measures of current inflation—which strip out backward-looking shelter readings from the Consumer Price Index—have already receded to near the Fed’s target range. But while there appears to be a growing consensus among Fed members to hold rates steady instead of enacting additional rate hikes in the near term, we don’t believe the economy is yet in the clear. That’s because we believe the full extent of the Fed’s 525 basis points worth of tightening has not fully worked its way through the economy. While a growing chorus has suggested that the full impact of rate hikes occurs much more quickly than historical estimates of 12 to 18 months, we believe this analysis is likely incomplete and would instead point to the makeup of financial obligations of consumers and businesses alike. Pre-COVID, businesses took advantage of historically low interest rates to borrow to meet their needs. Similarly, consumers took out mortgages—which account for the bulk of the average household's debt—at some of the lowest rates in decades. In both cases, these debts have yet to fully reprice to today’s much higher interest rates. As such, neither businesses nor consumers have taken the full brunt of the elevated cost of capital. So far, the hikes over the past 19 months have affected interest rate-sensitive areas of the economy, such as real estate, where homeowners have been hesitant to swap out low-rate mortgages. Consider that as of the end of the second quarter in 2023, the rate on outstanding mortgages was 3.6 percent. At the end of last week, the national average for new mortgages was 8.01 percent. However, we believe many other areas have been largely untouched but will soon be experiencing the drag from higher borrowing costs.

As such, we have not strayed from our baseline expectation that a recession is likely in the coming quarters. However, with current inflation continuing to recede and inflation expectations in line with historic norms, we believe the Fed should be able to pivot quickly to stem a potential economic contraction once the employment picture softens and wage growth is tamed.

A word on the Treasury market. Last Thursday the yield on the 10-year Treasury briefly rose above 5 percent before closing at 4.91 percent. The rise stemmed from a reassessment of long-term bond yield prospects by fearful investors. However, based on the difference between 10-year Treasury yields and inflation expectations, the 10-year Treasury is yielding 2.45 percent on an inflation-adjusted basis. While we acknowledge that risks have increased, we feel comfortable that the current level of real interest rates provides adequate compensation against these risks for long-term investors.

Wall Street wrap

Consumers continue to shop: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in September were up 0.7 percent, down slightly from August’s upwardly revised reading of 0.8 percent but more than double Wall Street’s expectations. The latest data shows retail sales are up 3.8 percent on a year-over-year basis. Sales strength was concentrated in a few areas, with vehicles, non-store retailers (i.e., online), and food services and drinking places seeing strong growth and accounting for 0.5 percent of the total 0.7 percent rise. While the sales numbers are not adjusted for inflation, the latest monthly reading indicates that consumers continue to spend despite their paychecks losing purchasing power. Whether this trend can continue is unclear. The Federal Reserve Bank of San Francisco believes that the excess savings that consumers stockpiled during COVID will run out this quarter and another recent Fed study showed the bottom 80 percent of households by income have used up their excess savings and now have less in the bank on an inflation-adjusted basis than they did in March 2020.

NAR existing home sales decline further: The National Association of Realtors (NAR) reported that existing home sales in the U.S. declined 2 percent in September to a seasonally adjusted annual rate of 3.96 million units. On a year-over-year basis, sales of existing units are down 15.4 percent. This marks the slowest pace since late 2010 and is well off the post-COVID high of 6.56 million set back in October 2020.

The inventory of unsold homes was 1.13 million units, up 2.7 percent from August. With existing homeowners showing an unwillingness to sell due to elevated mortgage rates, some homebuyers have turned to new construction. The latest housing starts data from the U.S. Census Bureau shows residential starts increased 7 percent in September from the prior month, to a 1.358 million annualized rate. However, on a year-over-year basis, starts declined by 7.2 percent from September 2022. Single-family housing starts rose 3.2 percent from August’s revised pace to a seasonally adjusted annualized rate of 963,000 units. Meanwhile, multi-family starts were 383,000, up 17.6 percent from August’s revised pace of 327,000.

While starts were up in September, permits declined 4.4 percent from August to 1.473 million. While single-family permits edged 1.8 percent higher than the prior month to 965,000, multi-family permits tumbled by 14 percent for the month and are now down 31.6 percent year over year. Overall, these numbers remain well below their post-COVID highs. We expect the recent surge in mortgage rates, to well above 7 percent, will likely weigh further on these numbers going forward.

Home builders’ concerns grow: Despite the uptick in housing starts last month, home builders are growing increasingly concerned about interest rates. The latest sentiment reading from the National Association of Home Builders came in at 40, down from the prior month’s downwardly revised reading of 44. The latest report marks the third consecutive month of declining optimism and the second straight sub-50 reading, as mortgage rates continue their climb to decades-high levels. To combat the impact of higher interest rates, 62 percent of respondents reported offering some sort of incentive to entice buyers, with 32 percent reporting they cut prices on new homes. The average price reduction was 6 percent, according to the survey.

Forward-looking indicators continue to fall: The latest Leading Economic Indicators (LEI) report from the Conference Board continues to suggest that the economy is either in recession or on the cusp of one. The September LEI reading declined 0.7 percent. The latest measure marks 18 consecutive months of decline. The reading is now down 6.8 percent on an annualized basis over the past six months. The six-month diffusion index (the measure of indicators showing improvement versus declines) rose to 60 percent, which is above the critical threshold of 50 percent; however, we expect downward pressure on that reading in coming months, as the prior two monthly readings showed declines. The Conference Board notes that when the diffusion index falls below 50 and the decline in the overall index is 4.2 percent or greater over the previous six months, the economy is in or on the cusp of recession. The diffusion index first fell below 50 in April 2022, and the overall reading first exceeded the negative 4.2 percent level in June of 2022.

While the latest data came in slightly stronger than the criteria that has historically coincided with a recession, the report still suggests challenges to the economy going forward. In a statement accompanying the report, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “So far, the U.S. economy has shown considerable resilience despite pressures from rising interest rates and high inflation. Nonetheless, The Conference Board forecasts that this trend will not be sustained for much longer, and a shallow recession is likely in the first half of 2024.”

Beige book hints at easing tightness in the job market: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that, in aggregate, economic growth held steady from the prior reading. Perhaps the real news in the release was improvements in finding and retaining workers. Most districts reported slight to moderate increases in overall employment, and firms were hiring less urgently. Several districts reported improvements in hiring and retention as candidate pools have expanded and those receiving offers have been less inclined to negotiate terms of employment.

As it pertains directly to inflation, most districts reported price growth slowed or stabilized for manufacturers but continues to rise for the services side of the economy. Sales prices increased at a slower rate than input prices, as businesses struggled to pass along cost pressures because consumers had grown more sensitive to prices. As a result, firms struggled to maintain desired profit margins. Should profit margins continue to face pressures, businesses may turn to cutting payrolls to protect further erosion of margins.

Jobless claims decline: Weekly jobless claims were 198,000, down 13,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 205,750, down 1,000 from the previous week’s revised average. Continuing claims (those people remaining on unemployment benefits) were at 1.734 million, an increase of 29,000 from the previous week. While the initial claims number shows that layoffs remain subdued, the uptick in continuing claims may point to displaced workers facing greater challenges in finding new jobs.

The week ahead

Monday: The Chicago Federal Reserve Bank releases its national activity index. The report looks at economic activity across the country and related inflationary pressures, and we will be watching for signs that the economy is weakening under the weight of higher interest rates.

Tuesday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for October. Activity in manufacturing continues to show weakness, while the services side has shown continued resilience. We will be watching for signs to determine whether the services sector is seeing any erosion of strength as the cumulative effects of rate hikes continue to work their way through the economy. We’ll also be looking at demand for employment in both industries.

Wednesday: The U.S. Census Bureau will release data on new home sales for September. Last week’s Home Builders Index from the National Association of Home Builders showed optimism among builders has deteriorated in the face of rising interest rates, and we’ll be looking at this data to assess the impact on buyer behavior of new properties.

Thursday: We get our first estimate of third-quarter GDP. Wall Street estimates project growth coming in at 4.3 percent quarter over quarter. Despite the expected positive reading, we continue to believe that other measures, such as the Conference Board’s LEI, point to a likely recession in the coming quarters.

Data on durable goods orders for September will be released to start the day. We’ll be watching for signs that businesses are continuing to pull back spending in light of economic uncertainty.

Initial and continuing jobless claims will be announced before the market opens. Initial filings were down last week, and we will continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The September Personal Consumption Expenditures price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions.

Follow Brent Schutte on X (formerly Twitter) and LinkedIn.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.