The Recent Fed Rate Hike Doesn’t Spell As Much Doom As the Market’s Response

June 21, 2022

This past week, the Federal Reserve – the world’s most powerful central bank – increased its target lending rate by 75 basis points to a high of 1.75%. Judging by the market’s response, one would think that the world was ending. Recession, recession, recession continues to be the common cry. Let’s take a step back and look at where the Federal Funds rate stands in relation to its history, its relationship with some economic variables, and what it means for private equity.

Looking at the Federal Funds Rate from 1955

Here’s a look at the Federal Funds rate from 1955 forward. Highlighted in gray are U.S. recessions. In pink is the 4% threshold. Now, look closely at where the Federal Funds rate has floated prior to the onset of U.S. recessions. Notice anything? In all cases going back to early 1960s, the Federal Funds rate has been above 4% before the onset of a recession. The sole exception was the self-imposed pandemic recession of 2020. The current rate, at 1.75%, is still three 75-point rate hikes away from such a threshold. Of course, if the Fed Board opts to raise rates in each of the next three meetings (July, September, and November), then the upper range of the target rate will be right at the 4% threshold. But, even at 4%, are we likely to enter a recession? If the 1970s and 1980s experience are the periods most similar to today, the answer is no. There likely won’t be a recession in 2023, assuming the Fed avoids going hog wild on the rate increases.

Source: Econometric Studios

The Yield Curve Suggestion

Switching to the yield curve, often considered the best predictor of potential recessions, suggest a U.S. recession is still at least two years off. Typically, once the bottoming of the 10-year yield less the 2-year yield happens, a recession occurs in around a year. Presuming it takes another 6 months to a year to reach the bottom, which suggests a recession in 2023 is less likely than 2024.

Source: Econometric Studios

What does this mean for private equity?

What does this background mean for private equity? Well, it depends. The rising interest rates will certainly put pressure on leveraged buyouts and make other deals less attractive. But, what it doesn’t mean is that valuations will drop significantly because of a pending recession. That view is, as of now, unwarranted.

Summing Up

Overall, although the market’s recent response to rising interest rates suggests an imminent recession, the likelihood within the next 18 months is actually much less probable. It’s likely markets, including the private equity market, will continue to be volatile over the coming months, but the economy will more than likely avoid a recession.

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