A Closer Look at the Fed's 'Soft Landing'

As we move into the final countdown to the US elections, I wanted to address the heavily touted concept of our economy having a so-called soft landing.  This occurs when the Fed successfully tames strong inflationary pressures with sharp interest rate hikes, and then manages to lower rates at just the right pace in order to guide the economy towards stable growth without inducing a recession in the process.

As far as I have seen, the only time the Fed managed to accomplish this deft maneuver was in 1994-1995.  The world was a very different place at that time.  Germany was still moderating the explosive growth that followed the massive investment associated with the unification of East and West Germany during the prior years.  Japan was reeling from its bubble-economy bursting, and China’s economy was growing at 9% a year as they entered the global economy in a massive way as a low-cost producer of goods for the West.  In fact, the late 1980’s and early 1990’s ushered in a thirty-year cycle of disinflation which made the job of central bankers much easier. 

The broader disinflationary pressures enabled central bankers to err on the side of easing without having to worry too much about inflation rearing its ugly head except in rare instances.  This cycle enabled wholly inexperienced and relatively unskilled central bankers to look like savants (sorry Mr. Brash, but you are a prime example) as they eased policy whenever they could without suffering severe negative repercussions.  Inflation tended to moderate naturally and easily without malicious side-effects. This was a major shift from the 1970’s and early 1980’s when inflation really needed to be aggressively fought by the central bankers.  

This time period really ushered in the idea of the Fed put, as the Fed found that they could err on the side of easing whenever trouble started to brew in the stock market, and the result was almost always a sharp recovery in the market without any major inflationary after-effects.  As you can see in the chart below, the so-called soft landing only occurred in the 1994-1995 period when Greenspan hiked rates aggressively to address some inflationary fears, and then aggressively cut rates when the inflation started to soften.  The result was an economy that continued to grow recession-free after the sharp rate hikes and subsequent easing by the Fed.

You will also note that the peak level of each interest rate hike has steadily decreased over time – until the recent hikes by Powell.  This was the by-product of globalization rather than the prescience of central bankers, but the effect of these broad market forces is that it tended to make the central bankers look a lot more skilled than they really were.

It remains to be seen whether the Fed can really achieve its fantasy soft landing whereby the US economy cools down just enough that the inflationary forces are quelled while the managing to avoid a recession.  The Fed has already proven to us that it is a fairly poor forecaster of inflation and economic growth.  Otherwise, they wouldn’t have pronounced that the surging inflation of 2021 was transitory while waiting far too long to hike rates aggressively to rein in the sky-rocketing prices.

The current job of the Fed is further complicated by a number of exogenous forces.  Without going into too much detail, consider the following array of factors that will all influence macroeconomic developments in a major way.  

1. The growing deglobalization forces that are manifested in significant tariffs, with the clear threat of more tariffs to come.  
2. A variation of deglobalization manifesting in the form of a direct challenge to the existing hegemonic role of the United States in global trade.
3. An aging population in the U.S.
4. Accumulated deficits in the United States (and elsewhere) that could very easily reach a tipping point over the coming years.
5. Growing disparity in wealth between the mega-wealthy and everyone else.
6. Development of AI and its potential negative impact on the jobs of millions of workers.

Due to the prior thirty years of steady disinflationary pressures, the Fed is predisposed to cut rates far more quickly than it raises them.  There are also political reasons for this bias as tighter monetary policy slows down economic activity by reducing the amount of money circulating through the country. Conversely, looser monetary conditions tend to be supportive of economic growth and the demand for goods and services.  Politicians like to stay in power, and a strong economy tends to keep their constituents happy.  Central bankers love to have high-paying gigs when they leave the Federal Reserve and supporting economic growth in general and Wall Street in particular tends to lead to cushy speaking gigs and advisory posts.  Therefore, both politicians and central bankers have a clear vested interest in maintaining easy monetary policy and strong economic growth.

In most elections, the economy tends to be the most important factor for voters, and this election is setting up to be no different from most.  The expected policy moves of both presidential candidates look to be inflationary, with strong biases to increase government spending at the expense of the long-forgotten goal of achieving a balanced budget.  Sure, there are differences in how they want to handle taxes and tariffs, but the bottom line for both political parties is that the implementation of their policies will be inflationary.

Based on the behavior of the Fed, it is clear that our central bank is far more tolerant of higher inflation than higher unemployment.  Core inflation is still over 3% on an annual basis, well above the Fed’s stated target of 2%, yet they happily cut rates by 50 basis points last month to further support the labor market. In case we had any doubts, that move clearly confirmed the asymmetrical bias of the Fed.  The risk going forward is that the Fed will engineer the worst of all possible scenarios, with sticky inflation and a slowing economy.  The employment data last month came in far stronger than expected, but based on the pattern seen in eleven of the past twelve months, those numbers will likely be revised much lower.  

The Fed’s nightmare scenario will be not just sticky inflation, but a resurgence in inflation while unemployment is rising,  The long-term effect of ballooning federal deficits is almost certainly going to bring about precisely that nightmare, but hopefully that scenario can be held off for a long, long time.  I am sure that the policymakers today want to avoid repeating the 1970s, when high inflation became entrenched, but they seem comfortable with the idea that 3% inflation might not be so bad.  I don’t think that the average consumer agrees with this idea as the cumulative impact of 3% annual inflation is crushing.  Consumers lose half of their buying power is roughly 23 years at that rate, and our average inflation rate for the past few years has been much higher than 3%.

We already have the least affordable homes in history, and things on that front don’t look much better.  Ten-year rates have continued to climb sharply since the Fed’s blunder last month, and the hoped-for drop in mortgage rates is not coming as hoped.  Frankly, it looks like the Fed may be boxing themselves into a corner.

Inflationary expectations are hard to tame.  Consumer expectations tend to be self-reinforcing, which leads to a vicious cycle of higher prices and higher wages – until finally rising unemployment results.  It is a delicate balance that the Fed is trying to pull off, and the ramifications of them failing will be severe.

The stock market is priced to perfection, and many things have to go right in order to sustain these levels.  We are slowly grinding ever higher, but the downside risk is growing.  I would really prefer to see one final spike rally before a huge correction, but it could be that there will be sufficient fresh buying to sustain a continued slow-motion climb before we finally start the sharp correction that I am anticipating. 

In terms of more specific forecasts, I want to revisit one of my favorite currency pairs, euro/cad, the Euro dollar versus the Canadian dollar.  I have been writing about euro/cad for a very long time, generally forecasting more structural moves that take a long time to play out.  Most recently I recommended on July 31, 2024, that the cross had reached my 1.5035 target and that it was time for a correction before the pair could finally break higher, heading up towards the 1.5900 level.  

The correction came, but my feeling is that the cross is just about ready now poised to take out the resistance between 1.5150 and 1.5225 and start its move towards the 1.5900 target.  More than with almost any other currency pair, patience is well-rewarded with euro/cad.  The move will be generally slow moving and quite easy to carry.  The risk-reward on the trade is excellent, as we are only risking about one and a half percent to make about six percent.  I like four-to-one odds in trades that I feel have a good chance of working out.

Otherwise, I also think there is substantial downside in the yen crosses as the yen’s corrective price action is nearing an end.  I don’t see these moves happening immediately, but over time, I really like these trades. From a longer time perspective, I think that the Canadian dollar and New Zealand dollar are both excellent shorts against the yen, but these cross plays will be far more volatile than the euro/cad cross.  For the nzd/jpy position, you need to be prepared to see a possible 2.5% to 3% squeeze higher before it resumes its powerful trend lower. I have written previously about the eventual downside targets for this currency pair, and my views are unchanged.  Eventually, the New Zealand dollar could collapse against the yen, but this will take a long time.  

For investors who hold significant long exposures to US stocks, an interesting point to consider is that short positions in cad/jpy and nzd/jpy are classic risk-off plays and accordingly could prove to be excellent hedges against a sharp move lower in the stock market.  The best thing about holding these positions is that they can make a tremendous amount of money even if stocks are chopping around in ranges or heading higher.  I always like to have hedges that can make money under multiple scenarios.

My view in gold remains unchanged.  We are nearing the end of a shorter-term cycle, so we are likely going to see a period corrective price action before heading still higher. My idea for this correction is that it will be more of a broad range trade, rather than a sharp sell-off.  I would guess the range will be roughly $2735 on the top and $2435 on the bottom.

In future write-ups I will start to share some of my ideas on some additional commodities as well as a few individual stocks.  We have been quite active with our trading across many markets, so I thought it might be fun to share a few ideas on these other trading opportunities.  Our trading has included different plays on things such as crude oil, high tech stocks, Coinbase, and some household names like Meta.  

In the meanwhile, wishing you the best of luck with your trading. 

Andy Krieger