Recession Roulette

The telltale signs of the U.S. sliding into a recession have ripped through global markets, with bond yields vacillating amid a broad repricing of frothy stock valuations. Listen to TCW's fixed income experts as they discuss the Federal Reserve's option to call an emergency meeting, aggressive policy measures to halt market hemorrhaging, and whether we're facing a new global financial crisis. David Vick hosts with guests Jerry Cudzil and Bret Barker in Los Angeles.

Creators and Guests

DV

Host

David Vick

BB

Guest

Bret Barker

JC

Guest

Jerry Cudzil

What is TCW Investment Perspectives?

TCW is a leading global asset management firm with over 50 years of investment experience and a broad range of products across fixed income, equities, emerging markets, and alternative investments. In each episode of TCW Investment Perspectives, professionals from the firm share their insights on global trends and events impacting markets and the investment landscape.

Seemingly, in the blink of an eye, the narrative has shifted.

Just a few weeks ago, there were people talking about the Fed
actually raising rates to contain stubbornly high inflation.

However, a string of weaker-than-expected data has brought the Goldilocks
economy, neither too hot or too cold, into question and raised the specter
of more aggressive easing from the Fed than previously anticipated.

I'm David Vick.

Welcome to TCW Investment Insights focused on Fixed Income Podcast.

Joining me here at our Los Angeles studio on this early August
Monday morning are Co-Head of Global Rates, Bret Barker, and Group
Managing Director and Generalist Portfolio Manager, Jerry Cudzil.

The moves the last week, Friday and this morning in
particular, have been dramatic to say the least.

While the action has been impressive, directionally
they've been very consistent with our expectations.

Our goal in this podcast is to put these moves into perspective,
discuss the implications for the global economy going forward.

So maybe Bret, we'll start with you.

Okay, so we've got a couple of things that have been big.

Can you kind of put those into context?

What started this?

What does it mean?

What are you seeing out there?

Thanks, David.

Listen, I think that the market is moving in the
direction, as you said, it's very consistent.

But I think we'd take a step back and say that
inflation has been the number one concern.

And I think if you look back at the June CPI report
that was released July 11th, that was a game changer.

I think you can see, look at some of the market pricing, especially for the
end, you think of the carry trade, that had a steep move after that report.

And within that report, I think that the market had been so focused on
this super-core, you know, where the Fed had been so focused on this
higher for longer for inflation, having to hold rates so restrictive.

That report showed back-to-back negative readings for super-core CPI.

And that means you're taking out food, energy, and shelter.

So really, that was supposed to be the Fed's
gauge for the employment for the service sector.

And I think that fits in with what we just saw
on Friday with the weak employment report.

It wasn't a disaster by any stretch, but if one sliver that the
Fed was holding onto was that super-core reading, it was soft.

And then you had the soft unemployment report, what
was happening in the pricing of the marketplace.

Yeah.

Well, what we would say, thanks, Brad.

I appreciate the insight.

Clearly, I think our view has been that this has been happening
over time, that there's been an underlying weakness in the
marketplace that is not being seen in the headline numbers.

And we've been heard that from some corporations,
and we'll get into that maybe a little bit later.

And now you get some confirmation.

You get confirmation from a one-week employment report.

And we've been talking about this.

The irony of where the markets were is that the markets were priced
for no volatility at a time when they were the most data-dependent.

And I think that's where you can get the outsized moves that we've been seeing.

And then we'll talk about putting this into context, because as outsized
as these moves seem today in what was a really low volatility environment,
as you take a step back, we think there's probably more to come.

Great.

Bret, you mentioned briefly about the unwind of the carry
trade and obviously the implications for this move globally.

You guys share a little more color there?

Well, I do think that if you...

That CPI report was a bit of a game changer.

I think if you look at what the rates market was pricing
especially is, we refer to it as put skew, or the
market's looking for buying protection for higher rates.

That collapsed after that report.

It's as if the market said the right tail risk of higher rates has been cut off.

So that really limits how high rates could go from that point on.

It was just a matter of how long do we stay
here, and the next move is going to be lower.

And I think when you see...

I think to Jerry's point, you don't really know how...

You know the market's been overpriced, price perfection.

You just don't know how much leverage is in the system.

I think that's what you've seen in the yen move, moving from a 161 market price
before they look now to 145 this morning, 142 you might never see this morning.

These price levels are as of the morning of
August 5th, and the market's very fluid.

So it's always harder to tell how this plays out
and how the markets could look one month from now.

So these large moves, and again, I think we've talked about it.

Yes, it's a yen carry trade.

Well, you might be funding short yen, but you're buying something else.

And I think the prime target there is probably the Mexican peso.

You've seen that a big move.

And that move for the weekend was a 20% draw down from the peaks in the Mexican
peso too, from right around that timeframe, right around July 11th until now.

So it's been very large moves.

You characterize that more as liquidity.

But again, to the point is the data has been showing some
weakness, but the market's just really been ignoring it.

Right.

And the unwind of some of these carry trades and the
unwind of the higher for longer narrative, at the moment
feels like just a removal of the restrictive policy.

We haven't yet, I think, gotten ourselves to the
point where we're beginning to price in a recession.

I think that there's more volatility to come because we just started
pricing in, getting back to where we were at the beginning of the year.

We still have less cuts priced in than when we walked in here in January.

And what we would tell you is inflation has come down in a significant way.

We would say the jobs market is weaker, certainly
than it was at the beginning of this year.

And the trend is as weak as it's been in quite some time.

And you had risk assets priced to perfection to the extent that you...

The narrative takes hold and we begin to price in a recession.

Well, that's a whole different level of anxiety in the markets.

It's also a whole different level of rates.

You remove the higher for longer, take terminal.

The expectations for the terminal rate back to what was considered normal
at the beginning of this year, which is two, two and a half percent.

And that'll leave risk assets significantly lower.

All right.

So that leads me to two questions.

First one is you mentioned your risk of recession, that sort of thing.

Are we seeing that risk reflected in our markets?

I mean, I think in other asset pricing, I know other
markets haven't been nearly as bumpy as treasuries lately,
but what are we seeing in other parts of the market?

Yeah, this is, I think, the key because always as an
asset manager, we love talking about the economy.

We love talking about a lot of different things.

Really, it only matters about its impact on
price and how we can navigate and outperform.

And when you take a step back and you look at the markets, the investment grade
credit index hasn't closed outside of a hundred yet on a year to date basis.

Today, it most likely will, depending upon where markets end up.

The high yield index is 50 wider essentially in the last month.

So that gets you to about 360.

These are not levels that imply a recession.

As a matter of fact, high yield, 200 basis points wider, about 550 or so is
where you would expect high yield to trade in as you enter a recession and
can go significantly wider as we know, as you move through a recession and
investment grade, certainly 150, 160, as you enter a recession, it can move.

It can move significantly wider.

So we do believe that risk assets themselves
still are not pricing in a recession.

As it gets back to the point of we're pricing in some removal of
restrictive policy, but we're not yet pricing in a recession.

Got it.

All right.

So the second question then is you referred to the Fed and the number of cuts.

So what's the outlook for the Fed from here?

Markets are pricing in a cut in September or
we've made one, one and a half cuts in September.

Heard there's some chance of an intermediate cut in there.

What are we thinking about the Fed and the path from here?

Well, I think it's very, you know, hits home correctly
with the saying is we really are early innings.

As of Monday morning, we had almost a 35% chance
of a 25 base point cut, an intermediate cut.

It seems a little odd for a couple of reasons.

One is usually if the Fed has to cut intermediate,
it's going to be 50 basis points, not 25.

So the 25 base point cut seems, seems a little odd.

And then second of all, I think because there's early innings and some of the
things we're seeing in the other asset markets, it's just really, it feels bad
and, and don't get me wrong, the Nikkei down wiping out the years returns is
not a good thing, but I think if you look where the S&P is at and some of the
things we're looking at in the US, it's not, it's not the emergency ring.

It's not time to ring the bell for the emergency
cut for the Fed at this point in time.

So I think, listen, the market's pricing at 50 base points in September.

Seeing how it evolves, we get one more payroll and two more CPI prints.

We'll see how this kind of goes.

But I think that, you know, for us is the policy is still restrictive.

I think Jerry brings that up.

And I say that because Fed funds are at five and a half percent,
but if you look at real rates, there's still almost 2%.

There was still 1.7, 1.8%.

That's still very restrictive.

That's not a low real rate where the Fed is easing.

That is still very restrictive.

I think we look at it, you've got 50 for September, a
little 120 for us the year, but another hundred for 25.

So that still puts a terminal rate north of 3%,
roughly three, three and a quarter in that range.

We still think that fair value or the neutral rate for Fed funds
is going to be two and a half, but the risk, they go to 2%.

So there's still more upside for being long duration in treasuries.

Yeah.

Cause the last thing we would say, just as, as it relates to an
emergency cut, we're not seeing any stress in the funding markets,
repo markets, inversion of investment grade credit curves.

The markets themselves are still acting normal.

So we are not of the opinion that the Fed should act in an emergency fashion.

We are of the opinion that the policy is significantly restrictive
and the Fed will lower rates faster than market expectations.

And we have been of that opinion and we think the Fed needs to lower
rates, but we don't think the Fed needs to move in an emergency fashion.

As a matter of fact, that could create more anxiety for the marketplace.

If they do, that could further magnify the volatility in the marketplace.

I know we have, everybody knows we have an election coming up.

Looks like it's going to be a contentious one.

Any thoughts on the implications of the election
on the Fed or on, you know, the broader markets?

That's a, that's a great point.

And I think that we all have to keep in mind, but I also would
caveat that, you know, the fundamentals will drive the Fed.

I think they've always somewhat being characterized as fighting the last war.

So they were late to raise rates too late in 21, 22.

And it's our view that they've overstayed their welcome
and they're going to be too late to, to cut rates.

And I think this is what you're seeing right now.

So they're going to have to respond to the data.

So as this economy is turning and if we expect the unemployment
to rise, rate is expected to rise and the job market to weaken
and inflation to slow down, we'd expect the Fed to rack.

So there's a lot of focus on the election,
what different policies might interact.

I think maybe our strongest view is that, you know,
neither party really has any call for fiscal austerity.

I think that it's going to be more of the same with
the risk that it probably goes, gets worse for us.

So that would probably be more treasury supply
as far as rates in the shape of the curve.

You know, overall deficit spending usually doesn't have
a big or high correlation with the level of rates.

It's the shape of the curve.

So I think for us that fits in with a steeper curve.

And if you've got the Fed reacting fundamentally to, to weaker date or cutting
rates, you should see the curve steep and you should see real rates rally.

And I think that's going to be driving the force versus the actual election.

Yeah.

I think that's a really good point, Bret, because when you think about the Fed
and the fact that they overstayed their welcome and what's going to drive them
to act historically, if you pull this back and we've looked back over the last
50 years, 50 years, it's more uncommon for the Fed not to act in
an election year than for the Fed to act in an election year.

They're really, they're going to respond to the data.

They don't, they don't have the luxury of not responding to the data.

And what we would say is what's really going to drive
this is the weakness, Bret's point about fiscal stimulus.

The narrative was that higher for longer.

And we need to be concerned about the backend of
the treasury market because supply might overwhelm.

You might get a pullback of foreign buying.

You might actually see the backend of the curve become unhinged.

And what happens is inevitably the economy slows down, the
world slows down, and where are you going to put your money?

The safe haven bid for treasuries comes back to the marketplace.

There's two dynamics going on here.

One is narratives can change really quickly.

And we saw that happen.

And I think the second is that the Fed is in a political organization.

They're not going to respond to the data, but
that does mean they have to respond to the data.

And to the extent that the data continues to come
in week, we do anticipate the Fed to respond.

Got it.

All right.

Well, let's wrap it up with one last question.

Just stepping back a bit.

Obviously the data has been soft as we've talked about.

We've talked about recession a little bit.

Like what's the outlook for the economy?

Sort of big picture going forward.

Are we looking at a financial crisis part two
or something a little more, a little more tame?

Yeah, maybe I'll start as Bret's hit on a number of the points.

What we would say is we're not of the opinion
that we're headed toward a financial crisis.

We are of the opinion the economy is slowing down in a significant way.

We have used this before where the plural of anecdotes data at
the company level, we get a significant amount of confirmation.

Whether you look at Lululemon or Starbucks or
Wendy's or McDonald's, the list is very Burberry.

The list is very long about the consumer, the stresses they're facing.

And then we're also seeing the loosening of the labor market at the same time.

And so our opinion is that the economy is slowing.

We will most likely enter a recession and that
recession will probably be a little bit longer.

We'll probably be a little bit slower.

There will be fits and starts.

We don't anticipate there to be a financial crisis.

It will not feel good and risk assets will reprice in a
material way, but we do anticipate there to be a significant
slowdown, an opportunity to add return on the back of this.

All right, great.

Thank you both for your input.

Thanks everyone for tuning into another edition of TCW's Focused on Finance.

Thanks for joining us today on TCW Investment Insights.

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