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 cut interest rates, lower bond yields and borrowing costs, and potentially support stock market valuations.
US economic data released in recent months show that inflation has moderated, the labor market remains resilient and the US economy is expected to expand at a healthy pace despite the Fed’s most aggressive rate hikes since at least the 1980s.
If nothing changes, it could cause problems for markets later in the year, according to several portfolio managers and market analysts.
Good news is bad news
US markets got off to a strong start to January as both stocks and bonds rallied.
The S&P 500 index SPX, +0.40%, is up nearly 4.2% and slipped just below 4,000 at the close on Friday, while the yield on the 10-year TMUBMUSD10Y Treasury note is up 3.505% in the range Down 30 basis points from about two weeks and was trading at 3.495% late Friday.
Lower yields have caused US Dollar DXY, -0.06%, to weaken rapidly, adding to the appeal of other safe havens such as gold. Gold GCG23, +0.07% Futures due to expire in February traded above $1,900 an ounce on Friday, the highest for one of the most active contracts since April.
However, when long-standing correlations between asset classes were turned on their head last year, an unusual dynamic emerged on Wall Street, with stocks and bonds falling simultaneously. Signs of a sound economy were met with disappointment as they implied the Federal Reserve would need to raise interest rates sharply to combat the highest inflation in 40 years in the wake of the coronavirus pandemic. As a result, stocks plummeted and government bond yields, which move inversely with 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 are anticipating from higher interest rates doesn’t materialize? What if there is no recession this year or only a slight economic slowdown and inflation continues to ease 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 high for longer.
“I think 2023 will be a year of volatility. The economy is already doing better than many expected, giving the Fed less incentive to cut rates,” said Mohannad Aama, portfolio manager at Beam Capital.
Is there a reckoning?
Unless things change, stocks could run into trouble later this year as investors are finally forced to face the reality that the Fed won’t change policy, according to Jonathan Golub, chief US equities strategist and head of the Fed quantitative research at Credit Switzerland.
The Fed won’t be able to cut interest rates, Golub said, because while commodity inflation is dissipating quickly, wage inflation is likely to remain “sticky”. And if the US economy continues to expand and unemployment stays low, the Fed will not be pressured into reviving it by cutting rates.
Golub believes stocks are likely to rise if the Fed halts rate hikes after making two 25 basis-point hikes, one after its early February meeting and the second after its March meeting.
But instead of a policy pivot, Golub expects the Fed to keep interest rates well above 5% through 2024. This is in line with Minneapolis Fed President Neel Kashkari’s comment, who says he expects the Fed’s interest rate to rise to 5.4%. or maybe higher.
“The Fed will get to that 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 come with time.”
Others agreed that markets are overestimating the likelihood that the Fed will return to cutting rates in the near future.
“The market is holding on to hope. It’s almost desperate for a pivot [from the Fed]said Matt McKenna, a longtime hedge fund research director who recently started his own company.
It’s different this time
Why are the markets so confident that a recession is imminent?
Because historically, that’s what happens when the Fed hikes rates, Steven Ricchiuto, 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 quick reversal and a significant cut in interest rates as the economy plunged into a credit crunch-induced recession,” he said.
“Only the Greenspan Fed’s pre-emptive rate hikes in the early 1990s are the exception to this tightening/credit crunch dynamic over the past 30 years.”
Investors will get more insight into the state of the US economy next week.
An update of the producer price index for December is due on Wednesday. The measure of wholesale prices may provide more insight into how quickly inflationary pressures are fading. Investors will also be able to get retail sales data for December, which is expected to reflect a drop in spending over the holiday season.
Several 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.