Why the odds of a recession just increased after Powell addressed Congress

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Thursday, March 9, 2023

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

Fed Chairman Jay Powell has just poured cold water on the “no landing” crowd in hopes of averting a U.S. recession and rallying stocks to new highs this year.

After two days of grilling in front of Congress, investors have (again) been reminded that the Fed chief still sees inflation as a persistent and pernicious threat.

Stocks and bonds were on notice on Wednesday as they both sold off amid rising short-term rates – leaving major indexes underwater for the week at the close.

“If all the data were to indicate that faster tightening is warranted, we would be prepared to accelerate the pace of rate hikes,” Powell told the Senate.

And with the next Fed meeting two weeks away, markets are now expecting exactly that. Bonds and derivatives are pricing a more hawkish outcome – expecting the Fed to hike its benchmark rate by 50 basis points instead of 25 basis points.

Since Monday’s settlement, the yield on US 2-year Treasuries has jumped 18 basis points to 5.06% – the highest level since 2007. It has also deepened its reversal against the yield at 10 years, with the spread reaching minus 108 basis points (or -1.08 percentage points) – the widest since the early 1980s, when Paul Volcker was the Fed Chairman waging a similar battle against US inflation. price.

Under normal conditions, interest rates on longer-term loans or bonds (the cost of money) should be more expensive than their shorter-term counterparts, because the risk is higher in the long term. But that changes when the Fed begins eradicating animal spirits, raising short-term rates to restrict credit creation and ultimately stifle growth.

While the breadth or depth of a yield curve inversion isn’t necessarily predictive of a deeper or longer recession, there are a host of other indicators in the bond market that sound the alarm.

Alfonso Peccatiello, former bond trader and CEO of TheMacroCompass.com, recently joined Yahoo Finance Live to share his insights.

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

Bond market digests Fed Chairman Powell's comments to Congress

Essentially, the inflation-fighting credibility that Powell has won in the markets comes at a cost — pushing Fed capitulation expectations far beyond what has happened historically.

“The problem is – the longer you keep tight private sector borrowing terms, the longer you keep mortgage rates high, the longer you keep corporate borrowing rates high – the more likely you are to freeze these credit and sleepwalking into a crash or, generally, accelerating a recession later,” Peccatiello said.

But long before the Fed provides relief in the form of cuts, Peccatiello expects stocks to suffer from an earnings slump, which he says “isn’t fully priced in.” (An earnings recession—marked by two consecutive quarterly declines in S&P 500 earnings—often, but not always, precedes an economic recession.)

Peccatiello thinks the US is already in a recession, with stocks reflecting complacency. Nevertheless, he does not expect a disaster. He sees around 10% maximum downside risk in the S&P 500 to the 3600 level, which is just around last year’s lows.

“I don’t think it’ll be much lower than that,” he says, adding, “(L) the stock market typically bottoms out before earnings bottom out.” The reason lies with the Fed, which historically capitulates and cuts rates as earnings fall.

Fed rate cuts are then priced into better stock valuations, which eventually halt the decline in stock prices, Peccatiello added. “(It) means the stock market can stop its decline and slowly but surely start entering a new bull market.”

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