They Don't Have a Scooby

20 June 2025

The challenge with forecasting is that human beings cannot see the future. That includes the Federal Reserve. As expected, the FOMC left policy unchanged at the June meeting. However, there was a notable divide in the committee on the reaction function to expected economic outcomes. Seven members of the committee thought that rates should remain unchanged for the remainder of the year, while eight still think that 50 basis points of easing will be justified. Mapping the reaction function of the committee is challenging given the forecast revisions.  Of course, if you start from the position that the Fed doesn’t really have a “Scooby Do” (clue) then the most important element to focus on is where you are being compensated for risk.

The summary of the economic projections in the Fed statement revised down growth and revised up inflation. The interest rate markets have priced 50 basis points of cuts by year end. However, the path of rates could change depending on how the data will evolve. The Fed Chairman indicated that increases in tariffs will likely boost prices. As we have noted, the fiscal impulse might remain firm under the proposed “Big Beautiful Bill” providing upside risk to inflation. US fiscal policy has been at “emergency levels” for some time despite the economy operating at full employment. Both factors have probably contributed to a rise in Treasury yields and the term premium.

While inflation expectations are elevated, there has been a deterioration in both the Citi US economic surprise index and the labour market under the surface. Although the unemployment rate remains low, partial indicators of the labour market (job openings, temporary hires, monthly revisions, and layoffs) undercut the “resilient labour market” narrative. The Challenger layoffs time series now rival those from September 2008 right before the systemic rupture went mainstream. The data might indicate fragility under the surface: where headline strength masked a rolling deterioration. Just like in 2008, we may be mistaking lagging indicators (like the unemployment rate) for structural health, when leading indicators (job cut announcements) are screaming stress.  

Chart 1

Source: Bloomberg

The good news for bond investors is that if there is a sharp deterioration in growth over the coming months it would likely undermine inflation expectations. Put another way, the “good outcome” for debt sustainability (bond demand) is a recession. The bad news is that the risk-reward in equities and credit is poor in that scenario. As we have noted, the S&P500 (global risk proxy) trades at 22 times forward earnings or in the 86th percentile of the 30-year valuation range. Equity and credit volatility tends to rise in a recession as the cash flow and profit cycle deteriorate. Of course, we don’t know if this will be the outcome. What we do know is that risk compensation is poor given the deterioration in some of the key leading indicators and policy risk. For example, equities most sensitive to tariff hikes have priced out most of that risk. We remain defensively positioned.  

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