Peak “Soft Landing”?

[This blog post is an excerpt from a commentary published at speculative-investor.com on 29th October 2023]

Thanks largely to rapid government spending, inventory building by the private sector and about $500B coming out of the Fed’s Reverse Repo (RRP) Facility, US ‘real’ GDP grew at an annualised rate of almost 5% in Q3-2023. The GDP number included strong quarterly growth in Real Gross Private Domestic Investment (RGPDI), which could be explained in part by investment incentivised by the Federal government’s misnamed “Inflation Reduction Act”. What are the implications for the financial markets of this economic activity surge?

With one important exception, all of the implications are in the past. It has been known for a few months that the GDP growth number for Q3 would be high, meaning that a high number was factored into market prices well before last week’s news. To the financial markets, what matters now is what’s likely to happen to economic activity over the quarters ahead.

We suspect that the GDP growth number that gets reported for the final quarter of this year will look fine, partly because money is coming out of the RRP Facility at a rapid rate (about $450B came out over just the past four weeks) and partly because the US federal government will continue spending as if there were no tomorrow. However, it’s likely that much weaker numbers will be reported during the first half of 2024 due to the lagged effects of monetary tightening, the exhaustion of the RRP liquidity channel, the effects on the US economy of recession in Europe, and reduced consumer spending in response to declining asset prices (stocks and real estate).

The one important exception mentioned above is the potential effect of the just-reported high GDP growth number on the future actions of the Fed. In particular, even if it is likely that the rate of GDP growth will be significantly lower in Q4-2023 and turn negative during H1-2024, the Fed tends to look backward and therefore could be encouraged by last quarter’s strong growth to stay tighter for longer.

It turned out, however, that during the hours following last Thursday’s announcement of the strong GDP growth number the expectations of the Fed Funds Futures (FFF) market shifted in a ‘dovish’ direction. Specifically, according to this market, last Thursday the probability of another Fed rate hike before year-end dropped from around 29% to around 20% and the expected Fed Funds Rate at the end of next year fell from 4.68% to 4.60%.

The market responses to last week’s strong US GDP number and generally good news on the corporate earnings front could be early signs that the financial world is beginning to move away from the “soft landing” scenario (the idea that the US economy will avoid a recession). This is to be expected, in that every recession begins as a soft landing and then turns into something more painful. The timing is usually difficult to pin down, though, because on the way to a recession there invariably are many twists and turns.