A flattening yield curve and plummeting consumer confidence have warned for months that U.S. recession risks are rising, but the alarm bells are suddenly amplified by a rare oddity in the futures market interest rates.
In technical terms, the June 2023-December 2023 Eurodollar curve has reversed. Clearly, traders are starting to price in interest rate cuts from the Federal Reserve in the second half of next year, before the tightening cycle has even begun.
This inversion had already been observed further along the curve, until 2024. But this was before the war in Europe, the vertiginous rises in the prices of oil, gas and raw materials, and the collapse of the world markets have radically changed the dial.
Admittedly, the Eurodollar curve is not a pure snapshot of the Fed’s expected policy path. It can be distorted by perceived credit risk and high demand for cover from a wide range of players, including foreign sovereigns.
But as Joseph Wang, a former trader on the Fed’s trading desk, points out, it’s unusual and deserves attention.
“It’s rare, but we have rare events going on. There’s huge uncertainty,” Wang said. “The core of the financial system, the banks, will be fine. the contagion and there could be repercussions that people don’t know about.”
FCI, HIGH 6 YEARS
Could the US economy fall into recession next year, or even this year? Economists are lowering their growth forecast for 2022 closer to 3% from 4% at the start of the year, with downside risks still largely due to oil. Average gasoline prices at US pumps are now the highest on record.
Annual growth of 3% would be far from close to contraction. But global geopolitical and financial developments are unfolding so rapidly that there is little visibility for the weeks ahead, let alone the rest of the year and beyond.
Global financial conditions are now the tightest in six years, according to Goldman Sachs’ Global Financial Conditions Index. Higher long rates, wider credit spreads, weaker equities have all contributed to the rapid tightening this year.
The direct exposure of the US economy to Russia, Ukraine and Eastern Europe is low. The Eurozone, for example, will be much harder hit by the raging conflict and energy prices.
But US consumer confidence has fallen to a 10-year low, and the 10-year Treasury yield is only 20 basis points from falling below the two-year yield. Every US recession in the past 40 years has been preceded by a sharp drop in consumer confidence and an inverted yield curve.
While high and rising inflation was on everyone’s radar at the start of the year, no one had a recession in their 2022 playbook.
“Markets should focus on the outlook for growth and the pace of its deceleration rather than inflation risk, which is already priced into bond and commodity markets,” Guilhem Savry of Unigestion wrote on Tuesday. .
A favorable growth outlook at the start of the year was one of the pillars on which the equally bullish and broad-based 2022 stock market consensus was built.
A quick look at the 2022 outlook for Wall Street banks shows that the “R” word has barely been mentioned. Yes, earnings growth might slow and valuations looked a bit rich, but as long as the economy avoids recession, Wall Street would still climb about 10%.
Bank of America research highlights the breadth of investor economic optimism and market optimism in January: the gap between bullish sentiment in equities and bearish sentiment in bonds was historically wide, only 7 % of investors expected a recession this year, and less than a third expected a bear market this year.
Most amazingly, BofA found that a record $949 billion was poured into global equity funds last year, more than the past 20 years combined.
Even assuming that some of this flow naturally evaporates as Wall Street declines – the Nasdaq went into a bear market this week – and most of it remains invested, there is still potential for huge changes in value. relative or reallocation towards safer assets.
“We are firmly in the grip of an incomplete bear market both in terms of time and price,” Morgan Stanley equity strategists wrote on Monday, adding, “As such, we recommend remaining biased towards defensively taking less risk than normal.”
Source: Reuters (by Jamie McGeever, with additional input from Mike Dolan; editing by Andrea Ricci)