Why recession odds just spiked after Powell addressed Congress

This article first appeared in the Morning Brief. Get the Morning Brief sent directly to your inbox every Monday to Friday by 6:30 a.m. ET. Subscribe

Thursday, March 9, 2023

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

Fed chair Jay Powell just poured cold water on the “no landing” crowd hoping to avert a U.S. recession and rally stocks to fresh record highs this year.

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

Stocks and bonds took notice Wednesday, as both sold off amid surging short-term rates — leaving the major indices underwater for the week as of the close.

“If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes,” said Powell before the Senate.

And with two weeks to go until the next Fed meeting, markets are now expecting exactly that. Bonds and derivatives are pricing in a more hawkish outcome — expecting the Fed to lift its benchmark rate 50 basis points instead of 25 basis points.

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

Under normal conditions, interest rates of longer-term loans or bonds (the cost of money) are expected to be more expensive than their shorter-term counterparts, as risk is higher on the long end. But this changes when the Fed starts stamping out animal spirits, lifting short-term rates to restrict the creation of credit and eventually choke off growth.

Story continues

While the magnitude, 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 are sounding 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 well over 5% a year from now. “That cannot happen if a recession is unfolding. The Federal Reserve will be forced to cut interest rates,” he said.

Essentially, the inflation-fighting credibility that Powell has earned in the markets comes with a cost — pushing expectations of Fed capitulation far beyond what occurs historically.

“The issue 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 freeze these credit markets and basically sleepwalk into an accident or, in general, accelerate a recession later on,” said Peccatiello.

But long before the Fed delivers relief in the form of cuts, Peccatiello expects stocks to suffer from an earnings recession, 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 believes the U.S. is already in an earnings recession, with stocks reflecting complacency. Nevertheless, he doesn’t expect a disaster. He sees about 10% maximum downside risk in the S&P 500 down to the 3600 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]he stock market generally bottoms before earnings bottom.” The reason gets back to the Fed, which historically capitulates and slashes rates as earnings drop.

The Fed rate cuts then get incorporated into better stock valuations, which eventually halt the decline in stock prices, Peccatiello added. “[This] means the stock market can stop its decline and start slowly but surely moving into a new bull market.”

What to Watch Today

Economy

Earnings

• Ulta Beauty (ULTA); Allbirds (BIRD); American Outdoor Brands (AOUT); BJ’s Wholesale (BJ); DocuSign (DOCU); FuelCell Energy (FCEL); Gap (GPS); JD.com (JD); National Beverage (FIZZ); Smith & Wesson Brands (SWBI); Vail Resorts (MTN); Zumiez (ZUMZ)

—

Click here for the latest stock market news and in-depth analysis, including events that move stocks

Read the latest financial and business news from Yahoo Finance