Every pilot after lifting the plane off the ground would plan, promise and hope that the flight will end in a soft landing. The same is true with Federal Reserve Chair Jerome Powell, who lifted interest rates from 0 in a series of rate hikes, citing soft economic landings in prior cycles as a guide to the current tightening campaign.

Financial markets, so far, seem tentatively to believe this is a plausible outcome: a successful series of interest rate hikes that pulls short-term interest rates up towards the neutral level, restraining inflation without dropping the economy into a hard landing -- recession. 

The S&P 500 is currently up about 3% from the recent low made the days before the Fed lifted rates 0.25% on March 16, but it was up as much as 10%. The 10% gain from March's lows was not sustainable after hawkish commentary from the Fed, regarding more aggressive rate hikes and quantitative tightening. The CME FedWatch tool now shows probabilities of a 50 basis point hike in May to be at 86.6%, up from 41.7% just a month ago. The 10-year Treasury yield has jumped to nearly 2.8%, the highest level we have seen since 2019. The 2-year Treasury yield, a closer proxy for anticipated rate hikes, has surged to 2.5%, the highest level we have seen since 2019 as well. The 10-2 year yield spread was briefly inverted to negative territory, which sparked worries of a recession, and then un-inverted again. The CBOE S&P 500 Volatility Index has sunk from an elevated 30 to a more normal 22-25 range. Altogether, this dynamic amounts to an implicit endorsement of the economy’s ability to handle higher interest rates. 

Today vs. Past Cycles

Powell cited soft landings in 1965, 1984 and 1994 in support of his case that one could be achieved again. For a few reasons, the 1994 tightening cycle has become the key touchstone discussed by economists and market commentators. In 1994, the economy was starting to run hot, but was immediately met with 3% rate hikes from Alan Greenspan over the course of a year. This forestalled a threatening rise in inflation (good), yet unemployment continued to fall (good) and corporate profits grew nicely (good). 

For markets, it was an anxious year with a genuine bond-market crash and a choppy stock environment, which ultimately emerged cheaper and primed for a run higher in 1995. Treasury yields soared from 6% in February 1994 to 8% by the end of the year. The Treasury yield curve between the 10-to-2-year flattened severely, but never quite inverted to negative territory. In 2022, the 10-to-2-year briefly inverted, but has sharpened to the upside again. 

As for stocks, the S&P 500 rushed to near-10% correction, then was rangebound, before breaking out in 1995. Jon Turek, a macro strategist at JST Advisors, plots the current S&P 500 path over that of 1994-’95 to find astounding similarities.

Equity valuations were under heavy pressure all year in 1994, from relatively modest levels to start with. The S&P 500 went from 15-times forecast 12-month earnings down to about 12-times that year. Currently, the S&P multiple is likewise receding, though from a richer starting point, slipping from 22.7 last April to 19.6 now, having dipped almost to 18 at the recent market lows.

Key differences

There are plenty of similarities between 1994 and now, but

For one thing, the Fed back then was acting in an intentionally and aggressive manner to restrain an economy at much higher levels of unemployment and before inflation became a problem, much less a political one. The unemployment rate was well above 6% when the Fed began tightening, compared to the great 3.8% of today. This Fed came into the current inflationary episode openly refusing to act pre-emptively against inflation. And, needless to say, inflation has run almost 3 times as much of the 3% CPI in 1994.

In ’94, after 3x 25bp hikes and 1x 50bp hike, the Fed did nothing for 3 meetings as policymakers assessed the impact. Today, there are discussions in the market that the Fed is front-loading a lot of the hawkish commentary and action (through the forms of a 50bp hike and some quantitative tightening), after that will wait and see how the inflation data behaves before determining further actions.

'94 was the very dawn of Fed policy transparency; the February rate-hike meeting that year was in fact the very first time the Fed had ever even announced and put in paper any change in the target Federal funds rate. Before that, the market simply had to figure it out based on the Fed’s own open-market operations. Today, the Fed has spent almost 4 months before the first rate hike to steer investor expectations to more aggressive tightening intentions. Arguably this has moved the markets a fair distance toward the pricing in of the tightening campaign – the S&P 500 is at the same level it reached seven months ago, having pulled back 13%, bonds pricing in at least 1.5 percentage points more tightening already.

Soft landing doubters

There is plenty of skepticism that a “perfect soft landing” is the going to be a likelihood. Roberto Perli, head of global policy research at Piper Sandler, says this: 

“Bottom line: 61 years of data, 8 recessions. All of them associated with Fed tightening in the vicinity of or above neutral. Only one clear exception to the rule (1994). The market seems justified in seeing increased risk of recession. Bonds already foresee rate cuts in 2023 into 2024.” 

For sure, there’s a chance that we are in a regime in which risk-asset rallies simply open up more daylight for the Fed to tighten more or sooner, a shift from the days when stock-market selloffs were a prompt for the Fed to stay easier for longer. This interplay could indeed cap market rallies and create a bumpier path – somewhat like 1994.