(Bloomberg) — As the likelihood of a recession declines on Wall Street, markets are again vulnerable to signs that the U.S. economy is running too hot.
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From high-interest loans to stocks, the likelihood of an economic downturn priced into financial assets has fallen to its lowest level since April 2022, according to JPMorgan Chase & Co. The recession was effectively considered a done deal.
This means markets are increasingly at the mercy of economic news that suggests a further rise in rampant inflation, spelling trouble for interest rate-sensitive strategies. For many investors, positive economic data – and its potential to spur further monetary tightening – are the headwinds they are grappling with.
“I’m concerned that the current good economic data will likely keep inflationary pressures simmering beneath the surface,” said Marija Veitmane, senior multi-asset strategist at State Street Global Markets. “That would stop the Fed and other central banks from cutting interest rates, which would ultimately ruin the economy.”
For example, solid jobless claims numbers on Thursday and service sector activity that beat forecasts on Wednesday strengthened the case for the Federal Reserve to keep interest rates elevated, leading to a decline in stock prices.
Even investors in Treasury bonds – one of the few markets where recession bets have gotten out of control – are feeling less gloomy these days thanks to a series of better-than-expected data.
The dreaded government bond yield curve inversion, a traditional economic warning sign, is finally easing. And traders have reduced their bets over the past two months on the extent to which the Fed will be forced to cut interest rates next year to combat a recession.
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One way to think about how sensitive the market is to new economic data: the connection between the S&P 500 and Citigroup Inc.’s widely followed surprise index for the U.S. economy.
That 40-day correlation has fallen to its most negative level ever, meaning stock prices fall if overall data from employment to manufacturing turns out to be stronger than economists expected. Conversely, a downward surprise triggers a rally.
The relationship between government bonds and data has also turned more negative, with economic strength pointing to weaker bond prices.
“We are in the ‘bad news is good news’ phase of the cycle and the reason is that the market is very worried that the Fed could raise interest rates again,” wrote Yung-Yu Ma, chief investment strategist at BMO Wealth a note.
A sudden spate of bad economic news clearly has the potential to trigger global volatility. But for now, good news may be the bigger risk, bringing inflation and higher interest rates that would hit corporate profits, curb business investment and threaten consumers with heavy debt burdens.
What Bloomberg’s strategists say…
“And so we find ourselves in a sort of economic and market purgatory, with the curve saying everything is going to hell, but risky assets holding out hope for a Nirvana-style soft landing.”
— Cameron Crise, macro strategist
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For their part, Fed policymakers are doing their best to thwart bets on a shift toward looser policy — and alert markets to potential rate hikes.
Traders have already cut the level of Fed easing they expect next year to about 100 basis points, down from well over 150 basis points in early 2023. The Fed is widely expected to keep rates in the range of 5, 25% to 5.5% will be left at the meeting on September 20th.
While the US economy is growing at 2%, even Fed officials have predicted a recession for this year. A widely followed, unofficial tracker from the Atlanta Fed expects the U.S. economy to have grown 5.6% on an annual basis in the third quarter.
“I think markets will be skeptical of a recession until they see the whites of their eyes,” said James Rossiter, head of global macro strategy at TD Securities. He now expects the U.S. economy to contract early next year after being surprised by it this year. “People like me have cried too many times over the past year over recession predictions, only to see the world turn out better than feared.”
Like him, investors across asset classes are rethinking their bets on a downturn. The equity, credit and interest rate markets combined estimate a 16% chance of a U.S. recession over the next six to 12 months, compared with more than 50% in October, according to a JPMorgan trading model.
The S&P 500 expects a recession probability of just 22%, down from 98% in October, while the junk bond market sees a 9% probability. The bank calculates the ratios by comparing the peaks of different classes before the recession and their troughs during the economic downturn.
Some worry that the turnaround has gone too far and that the healthy economy is pushing consumer price pressures so high that the Fed can’t comfort them. A soft landing, in which interest rate hikes slow inflation and the economy without crashing it, has eluded policymakers for much of the last half century.
“Goldilocks is more of a way station on the way to a better or worse growth environment,” said Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors. “In a stronger growth environment there should be greater inflationary pressures and the market will face further rate hikes.”
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