Schwab Market Perspective: Top of the Rate Cycle

What does a potential change in Federal Reserve policy mean for markets and the economy?

The Federal Reserve may hike rates again in May, but if so it's likely to be the last rate hike of the cycle. Although the Fed's favorite inflation indicator remains stubbornly high, the risk of a credit crunch and/or a recession has risen, particularly after banking stress appeared in March. This may mean additional volatility for the U.S. stock market; Asian stocks, on the other hand, may continue to offer more relative stability.

Fixed income: Peak of the cycle

We believe that U.S. interest rates are at or near their peak for the current cycle. The Fed may hike the federal funds rate one more time this spring, but we don't expect intermediate- to long-term rates to revisit the levels seen over the past six months.

It looks like the cumulative impact of the Fed's tightening in policy over the past year is working. After raising the federal funds rate at the fastest pace in modern times to cool off an overheating economy, demand growth is slowing and inflation pressures are easing. The latest data from the manufacturing sector have been weak and consumer spending has been softening. Inflation is still well above the Fed's long-term target of 2%, which may mean it opts for another 25-basis-point (0.25%) hike in rates at the Federal Open Market Committee (FOMC) meeting on May 2-3. However, with the risk of a credit crunch and/or recession rising, we see that as likely to be the last rate hike of the cycle.

The yield curve has been signaling for quite some time that rates have peaked and recession risk is rising. The yield spread between two-year and 10-year Treasuries dipped into negative territory more than a year ago. After a temporary rebound, the yield curve has been inverted (meaning long-term yields are lower than short-term yields) for more than nine months. Every recession since 1977 has been preceded by an inverted yield curve. The time frame between a yield curve inversion and recession has varied from as short as six months to as long as 22 months.

An inverted yield curve has preceded every recession since 1977

Chart shows the 2-year versus 10-year Treasury yield spread dating back to 1977, overlaid with gray bars showing the dates of economic recessions. An inverted yield curve preceded each recession, and the curve is inverted now.

Source: Bloomberg, monthly data as of 3/31/2023

Recessions as defined by the National Bureau of Economic Research. Past performance is no guarantee of future results.