Investors are ‘desperate’ for a recession to force the Fed to cut rates, but what will happen to markets if the economy stays healthy?

As 2023 kicks off, markets are holding on to expectations that the US economy will slide into a recession that effectively forces the Federal Reserve to start lowering interest rates, lowering bond yields and borrowing costs, and perhaps stock market valuations.

US economic data released in recent months shows that inflation has eased, the labor market remains robust and the US economy is expected to grow at a healthy pace by the end of 2022, despite the most aggressive rate hikes by the US. Fed since at least the 1980s.

If nothing changes, several portfolio managers and market analysts say it could spell trouble for the markets later in the year.

Good news is bad news

US markets got off to a strong start in January as both equities and bonds rallied.

The S&P 500 index SPX,
+0.40%
is up nearly 4.2% to just below the 4,000 mark at Friday’s close, as the yield on the 10-year Treasury TMUBMUSD10Y,
3.449%
is down 30 basis points in the space of about two weeks, trading at 3.495% late Friday.

Lower yields caused the US dollar DXY,
-0.06%
to weaken rapidly, increasing the appeal of other safe haven assets such as gold. Gold GCG23,
+0.07%
Futures expiring in February settled above $1,900 an ounce on Friday, the highest for a most active contract since April.

Last year, however, when long-standing correlations between asset classes were turned on their head, an unusual dynamic emerged on Wall Street, with stock and bond prices falling simultaneously. Signs of a healthy economy were met with disappointment, as they implied that the Federal Reserve would have to raise interest rates sharply to combat the highest inflation in 40 years in the wake of the coronavirus pandemic. As a result, inventories fell and government bond yields rose, which move inversely to prices.

Analysts have a name for this dynamic: they called it “good news is bad news” – meaning that “good news” for the economy was “bad news” for the markets. But what happens if all the bad economic news the markets are preparing for due to higher interest rates doesn’t arrive? What if there is no recession this year or only a mild economic slowdown and inflation continues to moderate but remains stubbornly high?

The answer is that both stocks and bonds could sell off again later this year as investors are forced to price in expectations that interest rates will stay high for longer.

“I think 2023 will be a year of volatility. The economy is already performing better than many expected, giving the Fed less incentive to cut rates,” said Mohannad Aama, portfolio manager at Beam Capital.

Will there be a bill?

If nothing changes, stocks could run into trouble later this year as investors are finally forced to reckon with the reality that the Fed will not change its policy, said Jonathan Golub, chief US equity strategist and head of quantitative research at Credit Swiss.

The Fed won’t be able to cut interest rates, Golub said, because while commodity inflation is fading quickly, wage inflation is likely to be “sticky.” And if the US economy is still growing and unemployment remains low, the Fed will not be pressured to revive it by cutting rates.

As Golub sees it, stocks are likely to rise when the Fed pauses its rate hikes after two 25 basis point hikes, one after the early February meeting and the second after the March meeting.

But rather than a policy pivot, Golub expects the Fed to keep its benchmark rate well above 5% in 2024. That echoes comments from Minneapolis Fed President Neel Kashkari, who says he expects the Fed Funds to interest rate will rise to 5.4%. or maybe higher.

“The Fed goes to this higher number, then they just go on autopilot and leave it there for a longer period of time — and that’s not fully priced in yet,” Golub said. “But that will be over time.”

Others agreed that markets are overestimating the likelihood of the Fed returning to rate cuts in the near future.

“The market is hopeful. It’s almost desperate for a pivot [from the Fed]said Matt McKenna, a longtime hedge fund director of research who recently launched his own venture.

This time it’s different

Why are the markets so sure that a recession is imminent?

Because historically, that’s what happens when the Fed raises rates, as Steven Ricchiuto, chief US economist at Mizuho Securities, said in a recent message to clients.

“Five of the Fed’s last six tightening cycles have been followed by a rapid policy reversal and a significant cut in policy rates as the economy entered a credit-induced recession,” he said.

“Only the preemptive rate hikes by the Greenspan Fed in the early 1990s are an exception to this tightening/credit crunch dynamic of the past 30 years.”

Investors will get more insight into the state of the US economy next week.

There will be an update on the producer price index for December on Wednesday. The measure of wholesale prices could provide more insight into how quickly inflationary pressures are easing. Investors will also receive retail sales data for December, which is expected to reflect a drop in spending over the holiday season.

There will also be several reports on the state of the US housing market, including data on the start of the housing market on Thursday and existing home sales expected on Friday.

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