Why recession odds just spiked after Powell addressed Congress

Why recession odds just spiked after Powell addressed Congress

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Thursday, March 9, 2023

Today’s newsletter is from Jared Blikre, a markets-focused reporter at Yahoo Finance. Follow him on Twitter @SPYJared. Read this and more market news on the go with the Yahoo Finance app.

Fed Chairman Jay Powell just poured cold water on the “no rate” crowd in hopes of avoiding a US recession and boosting stocks to new record highs this year.

After two days of grilling before Congress, investors were reminded (again) that the Fed chief still sees inflation as a persistent and damaging threat.

Stocks and bonds took the spotlight on Wednesday as both sold off amid a rise in short-term rates – leaving the major indexes under water for the week since the close.

“If the totality of the data shows that more rapid tightening is warranted, we will be prepared to increase the pace of rate hikes,” Powell said before the Senate.

And with two weeks to go until the next Fed meeting, markets are now expecting just that. Bonds and derivatives are being priced on a tougher score – expecting the Fed to raise its benchmark rate by 50 basis points instead of 25 basis points.

Since Monday’s settlement, the 2-year U.S. Treasury yield has risen 18 basis points to 5.06% — the highest level since 2007. It also deepened its rout over the 10- year, with the spread reaching negative 108 basis points (or -1.08 percentage points)—the highest since the early 1980s, when Paul Volcker was Fed chairman fighting a similar battle over inflation. prices.

Under normal conditions, interest rates on long-term loans or bonds (the cost of money) are expected to be more expensive than short-term ones, since the risk is higher in the long run. But that changes when the Fed starts crushing animal spirits, lifting short-term rates to limit credit creation and ultimately stifle growth.

The story continues

While the size or depth of a yield curve inversion is not necessarily predictive of a deeper or longer recession, there are a host of other indicators in the bond market that are ringing alarm bells.

Former bond trader and CEO of TheMacroCompass.com Alfonso Peccatiello recently joined Yahoo Finance Live to offer his insights.

Peccatiello notes that the bond market expects the Fed to fight inflation and remain tight, with interest rates above 5% a year from now. “That can’t happen if a recession is unfolding. The Federal Reserve will be forced to cut interest rates,” he said.

In essence, the anti-inflation credibility that Powell has gained in markets comes at a cost — pushing expectations of a Fed capitulation much further than what happens historically.

“The point is – the tighter you keep borrowing conditions for the private sector, the higher you keep mortgage rates, the higher you keep corporate borrowing rates – the higher the chances you’re going to raise these credit markets and you will basically fall asleep in an accident. or, more generally, precipitate a recession later,” Peccatiello said.

But long before the Fed delivers relief in the form of cuts, Peccatiello expects stocks to suffer an earnings recession that, he says, “is not fully appreciated.” (An earnings recession—marked by two consecutive quarterly declines in S&P 500 earnings—often but not always precedes an economic recession.)

Peccatiello believes the US is already in an earnings recession, with stocks reflecting complacency. However, he does not expect a disaster. He sees about 10% maximum downside risk in the S&P 500 to the 3,600 level, which is right around last year’s lows.

“I don’t think it’s going to be much lower than that,” he says, adding, “[T]it generally bottoms out before earnings bottom out.” The reason goes back to the Fed, which historically capitulates and cuts rates as earnings fall.

The Fed’s rate cuts then feed into better stock valuations, which ultimately stop stock prices from falling, Peccatiello added. “[This] means that the stock market can stop its decline and begin to slowly but surely move into a new bull market.”

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