Resist the temptation

With good economic news in short supply, investors have responded to back-to-back reports of easing inflation with unwise elation. Below-consensus readings of CPI last week and PPI this week pushed equities prices up and bond yields down. This new narrative is that the U.S. economy not only avoids a rocky landing but finds an airstrip. This reading suggests that, with spreads widening across most fixed-income sectors, now’s the time to dip back into credit.  

That’s not our position. We don’t think the Federal Reserve will be able to set the economy down softly. It is laser focused on slaying the inflation dragon, even if that drives the country into a recession. A small decline in price pressures is hardly going to change that commitment. In our view, a conservative approach that resists the temptation to snap up cheap corporate bonds is warranted, at least for now.  

There are many signs we are heading for a downturn. The Conference Board Leading Economic Indicators Index has been negative for six of the past seven months, indicating a high risk of recession. The money supply is contracting as bank deposits drop. (The last time that happened on a sustained basis was when the word Great was followed not by “Recession” but “Depression”). The yield curve, another reliable recession indicator, remains inverted. And every time the unemployment rate has risen just half a percentage point, the economy has fallen into recession. The Fed projects its aggressive policy will increase the rate by nearly a full point.

The problem is that inflation lags the economy, typically rising for about a year even after the economy has rolled over. Because the Fed is chasing that with monetary policy that itself works with a lag, it’s no wonder it has never pulled off a soft landing when inflation has been as high as it is today. 

But perhaps the most compelling reason that it is too soon to add significantly to credit is simple logic. Any sustained rally in stocks and corporate bonds likely is doomed because Fed policymakers are apt to view it as a sign financial conditions are not tight enough. That could force them to hike rates even higher, short-circuiting those rallies. Even before a recession hits, their “good news is bad news” mentality suggests more pain ahead.

Yet, even as the U.S. approaches a slowdown, we are at least headed in the right direction for fixed-income investing. Higher rates and wider spreads really are creating real value in the bond market. We are simply holding out for a final capitulation sell-off in risk assets. The time to buy bonds and add back to the credit sectors is approaching. We’re just not there yet.