In our full year outlook for 2023 we discussed the trimodal distribution set and probabilities of a smooth, bumpy and hard landing. We said the economy was most likely to be “bumpy” this year with a moderately higher chance of a smooth landing and a low chance of a hard landing. So far, it looks like the smooth landing is unfolding, but I joined Oliver Renick yesterday on TD Ameritrade TV to discuss the possibility of a different scenario – the “trampoline landing”. This scenario is not just a smooth landing, but a big bounce in economic activity coming off of 2022.
While we are still in the “bumpy” landing camp (that is, the next 24 months are likely to be risky as the Fed navigates us through inflation and maintains a highly restrictive policy stance) the “trampoline” scenario is interesting to think about. In the interview I discuss how this is, in many ways, the Fed’s worst nightmare because it would increase the probability of a double bump in inflation.
As we know from the 1940s and 1970s inflation can be difficult to kill as both periods experienced a decline in inflation that then roared back to life later in the decade. This is precisely what the Fed wants to avoid so the “trampoline” scenario actually exacerbates the risks we see in the bumpy landing scenario because it would mean that the Fed is either going to be higher for longer or have to raise rates even more (for longer). If we get a big bump in growth we could end up bouncing out of the trampoline when the Fed snuffs it out once and for all.
Of course, there’s good and bad news in all of this. Higher interest rates exacerbate credit risk across the economy as credit rolls over into the new higher rate regime and demand for loans slows. This makes the future bumpy for higher risk assets. At the same time, higher rates are great for conservative investors because we’ve reached escape velocity in bonds (that is, current rates now offset most of the duration risk in bonds) and it also means we can clip 5.5% in T-Bills for many years to come. This is an incredible risk adjusted return for anyone who needs a lot of certainty in their liquidity bucket.
All in all, the economic data in 2023 has come in better than expected and a smooth landing scenario appears increasingly probable, but the longer the Fed remains restrictive the higher the short-term economics risks are.