Wall Street Fears Overheated Economy as Recession Race Falls

(Bloomberg) — Markets will again be hit by signs that the U.S. economy is running too hot, as the prospect of a recession on Wall Street.

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The odds of an economic downturn across financial assets, from high-yield debt to equities, have fallen to their lowest levels since April 2022, according to JPMorgan Chase & Co. The recession was effectively seen as a done deal.

That said, markets are increasingly at the mercy of economic news, another sign of rising inflation, spelling trouble for interest rate sensitivity strategies. For many investors, the positive economic data — and its potential to trigger more policy tightening — is the upside they’re fighting for.

„I worry that the current good economic data may keep inflationary pressures bubbling under the surface,” said Marija Weidman, senior multi-asset strategist at State Street Global Markets. „This would prevent the Fed and other central banks from cutting rates, which would eventually break the economy.”

Firm jobless claims figures on Thursday and service sector activity that topped all forecasts on Wednesday, for example, strengthened the case for the Federal Reserve to raise rates, prompting a fall in stocks.

Even investors in government bonds — one of the few markets where recession bets are running rampant — are less bearish these days, thanks to a string of stronger-than-expected data.

The dreaded inversion of the Treasury yield curve, a traditional economic warning sign, has long been easing. Over the past two months traders have been placing their bets on how much the central bank will be forced to cut interest rates next year to fight the recession.

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One way to think about how sensitive the market is to new economic data: the S&P 500 and Citigroup Inc. is a widely followed exclamation mark on the US economy.

That 40-day correlation has fallen to the most negative on record, meaning stocks are falling as big-picture measures from employment to manufacturing come in hotter than economists expect. Conversely a downside surprise triggers a rally.

The relationship between Treasuries and the data has also turned more negative, with economic strength pointing to weaker bond prices.

Yung-Yu Ma, chief investment strategist at BMO Wealth, said, „The reason the market is so concerned about the Fed raising interest rates again is that we’re in a 'bad news good news’ cycle as part of a cycle. A note.

A sudden flurry of bad economic news clearly has the potential to cause global volatility. But for now, the good news is that inflation and higher policy rates could be a bigger risk, hurting corporate earnings, reducing business investment and threatening consumers with higher debt burdens.

Here’s what Bloomberg’s strategists say…

„So we’re in a kind of economic and market purge where the curve says everything’s going to hell, but risky assets hold out hope of a soft landing like nirvana.”

– Cameron Grice, macro strategist

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For their part, Fed policymakers are doing their best to fend off challenges at a center for easy policy — and keep markets alive to the possibility of a rate hike.

Traders have already cut it to 100 basis points next year, from more than 150 basis points in early 2023. The Fed is widely expected to keep rates at 5.25% to 5.5% over the next year. Meeting on Sept. 20.

With the US economy humming along at 2%, even Fed staffers wrote a recession out of their forecasts for this year. The widely followed, unofficial tracker from the Atlanta Fed said the U.S. economy expanded 5.6% on an annualized basis in the third quarter.

„I think the markets will be skeptical about the recession until they see the whites of its eyes,” said James Rossiter, head of global macro strategy at TD Securities. After catching up this year, he now expects the US economy to contract early next year. „For the past year or so, people like me have cried wolf over recession forecasts, only to see the world turn out better than feared.”

Like him, investors across assets are rethinking the decline. Equity, credit and rate markets together assign a 16% probability of a US recession in the next six to 12 months, up from more than 50% in October, a JPMorgan trading model reveals.

The S&P 500 assigns just 22% odds of a recession, up from 98% in October, while the market for junk bonds sees a 9% chance. The bank calculates metrics by comparing various classes’ pre-recession peaks and their troughs during economic contractions.

Some worry that the reversal has gone too far, as a warm economy pushes consumer price pressures too high for the Fed’s comfort. A soft landing, rate hikes that slow inflation and keep the economy from collapsing have eluded policymakers for most of the past half-century.

„Goldilocks can be a one-way stop in a better or worse growth backdrop,” said Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors.

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