Investors are ‘desperate’ for a recession that forces the Fed to cut interest rates but what happens to the markets if the economy remains healthy?

As 2023 begins, markets are clinging to expectations that the US economy will slide into a recession that will effectively force the Federal Reserve to start cutting interest rates, lower bond yields and borrowing costs, and possibly help stock market valuations.

US economic data released over the past few months shows that inflation has moderated, the labor market remains strong, and the US economy likely expanded at a healthy pace to finish 2022, despite aggressive rate increases by the Federal Reserve since the eighties.

Unless something changes, this could spell trouble for the markets later in the year, according to many portfolio managers and market analysts.

Good news is bad news

US markets got off to a strong start in January as stocks and bonds rose.

S&P 500 SPX Index,
+0.40%
It is up about 4.2%, only close to the 4,000 level as of Closed on Fridaywhile the yield on the 10-year Treasury note is TMUBMUSD10Y,
3.449%
It fell by 30 basis points in a period of about two weeks and was trading at 3.495% late Friday.

Declining returns caused the US dollar DXY,
-0.06%
That weakens quickly, which increases the attractiveness of other safe-haven assets such as gold. gold gcg23,
+0.07%
Futures contracts due to expire in February settled above $1,900 an ounce on Friday, the highest level for the most active contract since April.

However, in the past year, as long-standing relationships between asset classes have been turned upside down, an unusual dynamic has emerged on Wall Street, with stock and bond prices falling at the same time. Signs of a healthy economy were met with disappointment as it indicated that the Federal Reserve would need to raise interest rates sharply to combat the highest rate of inflation in 40 years in the wake of the coronavirus pandemic. As a result, stocks have fallen and treasury yields, which move inversely to prices, have risen.

Analysts call 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 markets are bracing for higher interest rates not coming? What if there was no recession or mild economic slowdown this year and inflation continued to moderate but remained stubbornly high?

The answer is that both stocks and bonds could be sold again later this year as investors are forced to weigh expectations that interest rates will remain high for longer.

I think 2023 will be a year of ups and downs. “The economy is already doing better than many expected, which is giving the Fed less incentive to cut interest rates,” said Muhannad Aama, portfolio manager at Beam Capital.

account coming?

If nothing changes, stocks could run into trouble later this year as investors are finally forced to come to terms with the fact that the Fed will not be directing its policy, according to Jonathan Gollob, chief US equity strategist and head of quantitative research at Credit. swiss.

Golub said the Fed would not be in a position to cut interest rates, because while commodity inflation is fading quickly, wage inflation is likely to be “static.” And if the US economy continues to expand, with the unemployment rate remaining low, the Federal Reserve will not face pressure to revive it by cutting interest rates.

As Golub sees it, stocks are likely to rise when the Fed halts interest rate hikes after raising it twice by 25 basis points, one after its meeting in early February and the second after its meeting in March.

But rather than a pivotal policy, Golub expects the Fed to keep its benchmark interest rate well above 5% through 2024. This is in line with Comment from Minneapolis Federal Reserve Bank President Neel Kashkariwho says he expects the federal funds rate to rise to 5.4%, or possibly higher.

“The Fed will get to that higher number, and then they go on autopilot and leave it there for a long time — that’s not fully priced in yet,” Golub said. “But it will pass with time.”

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

“The market is holding out for hope. Almost desperate for a pivot [from the Fed]said Matt McKenna, a longtime hedge fund research director who recently launched his own venture.

This time it’s different

Why are markets so confident that a recession is imminent?

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

“Five of the last six Fed tightening cycles have been followed by a rapid policy reversal and large rate cuts as the economy plunges into a recession-inducing credit crunch,” he said.

“Only the Greenspan Fed’s precautionary interest rate increases in the early 1990s are the exception to this tightening/credit crunch dynamic over the past 30 years.”

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

An update to the Producer Price Index for December is due on Wednesday. A measure of wholesale prices can provide more insights into how quickly inflationary pressures are easing. Investors will also receive retail sales data for December, which is expected to reflect a contraction in holiday spending.

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

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