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

As 2023 progresses the markets are clinging to the expectation that the US economy will enter into a crisis that will force the Federal Reserve to start reducing interest rates, reduce bond yields and borrowing costs, and possibly support market valuations.

U.S. economic data released over the past few months show that inflation has slowed, the labor market is still strong, and the U.S. economy is expected to continue growing until the end of 2022, despite the Fed’s highest interest rate hike since 2022. 1980s.

Unless it changes, this could lead to problems in the markets by the end of the year, according to several portfolio managers and market analysts.

Good and bad news

US markets have had a strong start to January as stocks and bonds have rallied.

S&P 500 index SPX,
+0.40%
has risen nearly 4.2% to just shy of the 4,000 level since Friday’s close, while the yield on the 10-year Treasury note TMUBMUSD10Y,
3.505%
it has fallen by 30 points in almost two weeks and was trading at 3.495% at the end of Friday.

Lower yields have caused the US dollar DXY,
-0.06%
rapidly weakening, increasing the attractiveness of other safe-haven assets like gold. Gold GCG23,
+0.07%
Futures for February settlement settled above $1,900 an ounce on Friday, the highest for the contract since April.

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However, last year when the long-term relationship between the financial classes was turned on their heads, a strange change appeared on Wall Street, with stocks and bond prices both falling at the same time. Signs of a healthy economy were met with disappointment as he signaled that the Federal Reserve would need to raise interest rates sharply to combat a 40-year high in inflation due to the coronavirus pandemic. As a result stocks fell and Treasury yields, which move inversely with prices, rose.

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

The answer is that both stocks and bonds could sell off again later this year as investors are forced to price in the expectation that interest rates will remain high for a long time.

“I think 2023 will be an unstable year. The economy is doing better than many expected, which is giving the Fed an incentive to cut rates,” said Mohannad Aama, portfolio manager at Beam Capital.

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Counting coming up?

If nothing changes, stocks could go into trouble later this year as investors are forced to confirm that the Fed will not change its policy, according to Jonathan Golub, chief US equity strategist and head of quantitative research at Credit. Switzerland.

The Fed can’t cut interest rates, Golub said, because even if inflation is ending quickly, rising wages may be “sticky.” And if the US economy continues to grow, with unemployment falling, the Fed will face no pressure to stimulate interest rates.

As Golub sees it, stocks are likely to rise as the Fed suspends its rate hike after issuing two 25-month hikes, one after its meeting in early February and the second after its meeting in March.

But instead of policy, Golub expects the Fed to keep its interest rate above 5% until 2024. This is in line with comments from Minneapolis Fed President Neel Kashkari, who says he expects the Fed’s interest rate to rise to 5.4%, or maybe higher.

“The Fed gets to that high number, and then they just drive the car and leave it there for a long time — and the rate doesn’t get there,” Golub said. “But it will be a while.”

Others agreed with the view that markets are over-extending the possibility that the Fed will return to cutting rates soon.

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“The market is still holding on to hope. It is about to pivot [from the Fed]”said Matt McKenna, a hedge-fund research director who recently started his career.

This time is different

Why are markets so confident that a recession is imminent?

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

“Five of the Fed’s last six tightening measures have been followed by rapid policy changes and sharp rate cuts as the economy spiraled into recessions that caused the economy to collapse,” he said.

“The Greenspan Fed’s slow rate hikes in the early 1990s have been the focus of the credit expansion/debt expansion of the past 30 years.”

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

The price change for December will take place on Wednesday. A measure of inflation can provide more information about how inflation is slowing down. Investors will also receive retail sales data in December, which is expected to show a slowdown in spending during the holiday season.

Several reports on the US housing market are also due, including data from Thursday, as well as existing home sales on Friday.

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