Forget hard or soft – it may be a ‘no landing’ for the US economy

A ‘no-landing’ scenario, whereby the US economy re-accelerates after interest rate rises appears increasingly possible, says T. Rowe Price’s Scott Solomon.

The Marriner S. Eccles Federal Reserve Board building in Washington, DC. Picture: AFP

Investors were pleasantly surprised when Federal Open Market Committee officials trimmed their rate cut forecasts by less than expected after their March meeting, pushing the US sharemarket and gold up to record highs.

Even as they raised their growth and inflation forecasts after stronger than expected data since January, their median Fed funds rate projection for 2024 was unchanged at 4.6 per cent, implying three rate cuts of 25 basis points from the current target range of 5.25-5.5 per cent.

Their revised US rate forecasts for 2025 and 2026 imply about one rate cut less than previously forecast. The long-run forecast crept up to 2.6 from 2.5 per cent. But it was less of a rise than feared.

But rather than prepare for a coveted “soft landing” that officials obviously expect given their projection of 10 rate cuts by 2026, investors should consider the possibility of “no landing”.

A no landing scenario – where the economy re-accelerates from above-trend levels after interest rate hikes – has become more likely than soft or hard landings which would lead to large interest rate cuts, according to T. Rowe Price co-manager of dynamic global bond strategies Scott Solomon.

It’s a non-consensus view that has gained traction in recent months as the US economy proved surprisingly resilient to the most aggressive interest rate tightening in decades.

Baltimore-based T. Rowe Price is one of the world’s largest purely active fund managers.

It had about $US1.51 trillion ($2.28 trillion) of assets under management as of February.

Despite 500 basis points of rate hikes from March 2022 to July 2023, the US economy grew at a 3.3 per cent annualised pace in the fourth quarter versus 2 per cent expected by economists.

US CPI inflation for February rose by 3.2 per cent, year on year.

But the three-month annualised rate of the core PCE deflator – the Fed’s preferred inflation measure – has dived from around 5 per cent to 2.2 per cent in the past year, giving hope of a soft landing in the world’s biggest economy and substantial rate cuts by the powerful Federal Reserve.

Bloomberg’s survey of economists shows most expect the US economy to slow to a trend pace of around 1.7 per cent in 2025. Core PCE inflation is expected to fall to 2.1 per cent in that time.

The median recession probability estimate has fallen to 40 per cent from 65 per cent in early 2023.

But no landing implies higher than expected growth, inflation and interest rates in coming years.

Mr Solomon is guarding against this scenario in the portfolios he manages.

“So I’m pretty bullish on risk here overall,” he said.

He explained that in late 2023 and early 2024, market participants bought risk assets plus so-called “crash protection” via Fed funds futures and options, in case of a recession.

More recently that crash protection was wound back as the economy did better than expected, he said.

T. Rowe Price co-manager of dynamic global bond strategies Scott Solomon.

“That was sort of skewing the market to saying the Fed is going to cut six or seven times,” he said.

“You basically just had a lot of people buying tail protection, saying ‘I can buy a whole bunch of high yield over here, a whole bunch of stocks for the rest of my portfolio – if something really bad happens, I now know that the Fed is done fighting the inflation ­problem’.

“And I can go and buy a whole bunch of tail protection for cheap, so if we have some sort of black swan event – inflation really crashes, the labour market really eases up – that will pay off really for me because we the Fed cuts 12-16 times.

“Clearly that’s off the table now, so you’ve kind of had this roll back up, and it’s obvious now that the market and the Fed are pretty much in sync at three cuts for 2024.”

He said that in reality the market was always saying the Fed was going to cut three times.

Some market participants thought the median “dot-plot” projection for 2024 would fall to two cuts this week – only two FOMC officials needed to downshift – which explains the risk-on reaction.

“What I specifically expect to continue seeing now is a steepening of the yield curve,” he said.

“That what gold, bitcoin and stocks were saying – that there’s just a tremendous amount of liquidity out there. And with the Fed having your back, that just gives markets the ability to take extra risk.”

If one looks at the Fed funds rate versus where inflation – particularly core PCE – is annualising, he agreed that it “it looks really restrictive”.

“I think what the market is having trouble coming to terms with and also I think the Fed is having trouble really figuring out is how much easing is there in the really robust balance sheet that the Fed still has, how much easing does fiscal stimulus contribute to the economy,” Mr Solomon said.

The US budget deficit was more than 6 per cent of GDP in 2023. In Australia it was about 1.6 per cent.

“And is policy really as tight as it would seem, you know, based off of that relationship to inflation?” he asked.

“If you look at it purely from an academic perspective, yeah, the Fed is wildly restrictive, but you add these other things that people don’t have as much history in modelling, it’s actually a lot ­easier. It’s not as clear cut as it used to be and there’s a lot more art than science to it.”

Importantly, he said Fed chair Jerome Powell had indicated that the labour market could stay where it was and the Fed could still cut rates, but it needed more confidence on inflation sustainably going to target.

“What I’m really trying to defend against is the Fed over-easing financial conditions and you actually get yields not falling nearly as much as the market believes and yields actually move higher, particularly further out the yield curve,” Mr Solomon added. “When you finally get the front end of the (bond) market to calm down and not have a ton of volatility to it, that’s when you can really get the back end of the curve to steepen a lot.

“In Australia you have a relatively steep yield curve, but in the US it’s still relatively inverted.

“To really get the US economy going, the US economy works better with a normalised yield curve.

“That’s where banks can do the traditional borrowing short and lending long – it doesn’t work right with an inverted yield curve.

“At some point I think the Fed and Treasury will work together to get that a little steeper.”