Wall Street sees the Fed starting to signal toward a recession ahead

Published Thu, Mar 23 20232:27 PM EDT

The Federal Reserve this week laid out a rough blueprint of where it thinks both the economy and policy are going, and prepared markets for the likelihood of a substantial economic slowdown ahead. Whether that morphs into a recession is anyone's guess at this point, but Fed Chairman Jerome Powell and his fellow central bankers strongly indicated they don't see much to get excited about. The Wall Street consensus after the Federal Open Market Committee meeting concluded Wednesday was equally cautious. "Our banks analysts see a meaningful increase in funding costs ahead, which would lead to tighter lending standards, slower loan growth, and wider loan spreads," Ellen Zentner, chief U.S. economist at Morgan Stanley, said in a client note. "We were already expecting a meaningful slowdown in growth and job gains over the coming months, and the prospect of substantial tightening in credit conditions raises the risk that the soft landing we project turns into a harder one," she added. Those comments reflected observations Wednesday from Powell, who noted that the recent banking crisis will slow growth through tighter financial conditions such as less lending and a slowdown in hiring. In turn, the Fed projected that its succession of rate hikes begun a year ago this month are likely nearing an end, following Wednesday's 25 basis point increase in the federal funds rate. "We took the broad signals from this meeting as lifting perceptions of recession risks within the Fed," wrote Matthew Luzzetti, chief U.S. economist at Deutsche Bank. "Powell noted that recent events will certainly not reduce recession risks, even if how much they heighten those risks remains uncertain." The risk from rates Worries remain that more Fed rate hikes will exacerbate banking problems by creating more duration risk. That's what happened to Silicon Valley Bank when it had to sell long-duration assets at a loss to cover a run on deposits. For his part, Powell seemed to indicate that the interest rates would address persistent inflation, while the lending programs the Fed has at its disposable can address bank liquidity concerns. Markets, though, think the Fed is done with rate hikes. Though the FOMC's "dot plot" pointed to one more hike, taking the terminal rate to 5.1%, traders on Thursday weren't buying it. Futures contracts showed a 66% probability that the Fed would stay put at the May meeting, according to the CME Group's FedWatch indicator . From there, the market expects the Fed to hold steady in June and then start cutting in July. Most Wall Street analysts, though, took Powell at his word that cutting is not part of the central bank's baseline outlook this year. "We expect the FOMC to hike another 25bp in May, bringing the funds rate target range to 5.00-5.25%," wrote Barclays chief U.S. economist Marc Giannoni. "We expect it to pause afterwards and maintain this range through the rest of the year. This projection assumes that the turmoil does not morph into a severe financial crisis, and that volatility diminishes." Downside scenario JPMorgan Chase and Bank of America likewise say they expect the Fed to follow through with one more 25 basis point hike, while Citigroup figures the Fed to tack on two more after that, taking the funds rate to a target range of 5.5%-5.75%. However, much of the post-meeting commentary focused on looming dangers to the financial system that could make the Fed retreat rather than forge ahead. Goldman Sachs economist David Mericle, for instance, said the higher rates "raised the odds of a more serious downside scenario." While he added that the base case is not for a severe downturn, there are some key variables in play. "One other change to our thinking is that we are increasingly open to the possibility that a persistently deeply inverted yield curve could add to strain on banks' financial health enough to be at least one contributing rationale for lowering the funds rate in the future," Mericle wrote. —CNBC's Michael Bloom contributed to this report .