Investors are ‘desperate’ for recession forcing Fed to cut interest rates, but what will happen to markets if the economy remains healthy?

As 2023 progresses, markets are clinging to expectations that the U.S. economy will enter a recession, forcing the Federal Reserve to cut interest rates, reduce bond yields and borrowing costs, and possibly help stock prices.

U.S. economic data released over the past few months suggest that despite the Fed’s most aggressive rate hike since at least 2022, inflation is likely to moderate, the labor market will remain firm, and the U.S. economy will likely expand in a healthy manner to finish 2022 . 1980s.

According to several portfolio managers and market analysts, if something doesn’t change, it could spell trouble for the markets later this year.

Good news is bad news

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

S&P 500 index SPX,
At Friday’s close, it rose nearly 4.2% to just shy of the 4,000 level, while the yield on the 10-year Treasury note TMUBMUSD10Y,
It has fallen 30 basis points in nearly two weeks and was trading at 3,495% late Friday.

Lower yields led USD DXY,
rapidly weakening, increasing the appeal of other safe-haven assets such as gold. Gold GCG23,
Futures for February settlement crossed $1,900 an ounce on Friday, the highest for the most active contract since April.

However, when the long-standing correlation between asset classes collapsed last year, an unusual dynamic emerged on Wall Street, with stocks and bond prices falling simultaneously. Signs of a healthy economy were met with disappointment as they suggested the Federal Reserve would need to raise interest rates sharply to combat the highest inflation in 40 years following the coronavirus pandemic. As a result, stocks fell 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 is produced by the markets as a result of high interest rates? What if there is no recession this year, or just 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 remain higher for longer.

“I think 2023 will be a year of change. 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.

Coming up with a bill?

According to Jonathan Golub, chief US equity strategist and head of quantitative research at Credit, if nothing changes, stocks could face trouble later this year as investors finally come to terms with the reality that the Fed has no intention of changing policy. Switzerland.

Golub said the Fed won’t be able to cut interest rates because wage inflation is likely to be “sticky” while commodity inflation dissipates quickly. And if the U.S. economy is still expanding, with unemployment remaining low, the Fed will face no pressure to stimulate it by cutting rates.

As Golub sees it, when the Fed stops raising rates after two 25 basis point hikes, one in early February and the second after the March meeting.

But instead of a policy line, Golub expects the Fed to keep its benchmark interest rate well above 5% until 2024. That’s in line with comments from Minneapolis Fed President Neel Kashkari, who said he expects the Fed to raise interest rates to 5.4%. or maybe even higher.

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

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

“The market holds hope. It is almost hopeless [from the Fed]”said Matt McKenna, a longtime hedge fund research director who recently launched his own venture.

This time is different

Why are markets so convinced that a recession is inevitable?

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

“Five of the last six Fed tightening periods were followed by a rapid policy shift and a significant reduction in policy rates as the economy slipped into a credit crunch-induced recession,” he said.

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

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

An update on the producer price index for December will be released on Wednesday. A measure of wholesale prices can provide more information on how quickly inflationary pressures are easing. Investors will also receive retail sales data for December, which should reflect a fall in spending during the holiday season.

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

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