Investors are “desperate” for a recession that forces the Fed to cut interest rates, but what will happen to markets if the economy remains healthy?

Investors are “desperate” for a recession that forces the Fed to cut interest rates, but what will happen to markets if the economy remains healthy?

As 2023 kicks off, markets are clinging to expectations that the U.S. economy will slide into a recession that effectively forces the Federal Reserve to start cutting interest rates, slashing bond yields and borrowing costs, and perhaps help stock market valuations.

U.S. economic data released over the past few months shows that inflation has moderated, the labor market remains robust, and the U.S. economy has likely grown at a healthy pace to end 2022, despite increases in Fed’s most aggressive interest rates since at least the 1980s.

Unless something changes, that could create problems for the markets later in the year, according to several portfolio managers and market analysts.

Good news is bad news

US markets got off to a good start in January as stocks and bonds rebounded.

The S&P 500 SPX index,
rose nearly 4.2% to just below the 4,000 level at Friday’s close, while the yield on the 10-year Treasury TMUBMUSD10Y,
fell 30 basis points in the space of about two weeks and was trading at 3.495% on Friday evening.

Falling yields caused the US dollar DXY,
weaken quickly, increasing the appeal of other safe havens like gold. Gold GCG23,
Futures due to expire in February settled above $1,900 an ounce on Friday, the highest for the most active contract since April.

However, last year, as long-standing correlations between asset classes were upended, an unusual dynamic emerged on Wall Street, with stock and bond prices falling at the same time. Signs of a healthy economy were met with disappointment as they implied the Federal Reserve would have to raise interest rates sharply to tackle the highest inflation in 40 years in the wake of the coronavirus pandemic. As a result, stocks crashed and Treasury yields, which move inversely to prices, rose.

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 when all the bad economic news that markets brace for due to rising interest rates doesn’t arrive? What if there is no recession or only a mild economic slowdown this year and inflation continues to moderate but remains stubbornly high?

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

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

A settling of scores to come?

If nothing changes, equities could run into trouble later this year as investors are ultimately forced to factor in the fact that the Fed is not going to pivot policy, according to Jonathan Golub, chief U.S. equity strategist and responsible of quantitative research at Credit Suisse.

The Fed won’t be able to cut interest rates, Golub said, because if goods inflation dissipates quickly, wage inflation is likely to be “sticky.” And if the US economy is still expanding, with unemployment remaining low, the Fed will not be under pressure to revive it by cutting rates.

According to Golub, stocks will likely rally when the Fed suspends its rate hike after making two 25 basis point hikes, one after its meeting in early February and the second after its meeting in March.

But instead of a policy pivot, Golub expects the Fed to keep its benchmark interest rate well above 5% through 2024. This is in line with comments from the Minneapolis Fed Chairman , Neel Kashkari, who says he expects the federal funds rate to rise to 5.4%, or possibly higher.

“The Fed is going to get to that higher number, and then it’ll go on autopilot and leave it there for an extended period — and it’s not fully priced in yet,” Golub said. “But that will be in time.”

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

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

This time it’s different

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

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

“Five of the last six rounds of Fed tightening have been followed by a rapid policy reversal and a significant cut in key rates as the economy plunged into a credit crunch-induced recession,” he said. -he declares.

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

Investors will receive more information on the state of the US economy next week.

An update to the producer price index for December is due out on Wednesday. The wholesale price gauge could offer more insight into how quickly inflationary pressures are moderating. Investors will also receive retail sales data for December, which should reflect a contraction in spending over the holiday season.

Several reports on the state of the US housing market are also expected, including housing starts data on Thursday and existing home sales due out on Friday.

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