JPMorgan Ponders ‘Armageddon’ Scenario

“Pause is not enough.”

That’s one of four possible macro scenarios included in JPMorgan’s 2023 economic outlook. The others are “Damage done and broad,” “Slip-sliding away” and “Soft landing.” Three entail recession.

The odds are somewhat evenly distributed. The figure (below) shows the subjective probabilities and describes the policy and macro conjuncture behind each scenario.

As you can see, the base case (by a very narrow margin) finds the US slipping into a mild downturn late next year, with Fed funds peaking around 5% and the Fed delivering “modest” easing in 2024.

The second-most likely outcome entails the resumption of Fed hikes in the back half of next year, presumably as inflation refuses to abate with rates at 5%. In that scenario, the Fed raises rates as high as 7% which, I’d note, would be consistent with the “less-generous” Taylor rule approach presented by Jim Bullard at an event in Louisville last month.

This all comes back to what counts as “sufficiently restrictive” (to employ the Fed’s new favorite catchphrase) vis-à-vis putting inflation on a sustainable path back to 2%. I’ve variously suggested that achieving 2% inflation might be impossible in the near-term (maybe in the medium-term too). At least one analyst alluded to the same this week.

Fed officials have given no indication that they’re prepared to revisit the definition of price stability, though, which presumably means that prior to any kind of concession that involves revising the inflation target, policymakers would make one last go at it, where that could conceivably mean raising rates as high as 7%.

That outcome (or something like it) would probably be “followed by a deep recession or hard landing in 2024,” JPMorgan said, adding that the Fed would then be compelled to “cut rates aggressively.” The bank assigns a 28% probability to that outcome. Markets, by contrast, “price in around 10% probability that the Fed funds rate will be at 6.5% or above for options expiring in September 2023,” Nikolaos Panigirtzoglou said, on the way to noting that although it may be “too early for markets to start focusing on this scenario” it’s “conceivable” that traders could begin to focus on it “at some point in Q2” if there’s no resolution to the various macro riddles clouding the outlook.

Panigirtzoglou said that the bank’s clients consider the “Pause is not enough” outcome an “Armageddon scenario.” “After all, the last time the Fed funds rate was at 6.5% was in 2000 and that level of policy rates was followed by very heavy losses for risk markets at the time,” he wrote.

The good news is that “Armageddon” might be too hyperbolic for the downside that would likely accompany 6.5% Fed funds. “Demand for both bonds and equities declined by so much in 2022 that it would be more difficult for another big decline in demand to take place in 2023,” Panigirtzoglou remarked.

For bonds, the demand outlook is already pretty grim. In fact, the bank sees negative net demand when you factor in QT. That’d be “unprecedented” (figure on the left, below). It could get more unprecedented, but Panigirtzoglou noted that although the front-end selloff would be vicious in the event the Fed hikes to 6.5%, the long-end surely wouldn’t keep up, leading to an even deeper inversion, even higher odds of recession and thereby a bid for bonds eventually.

To assess the drop in equity demand, the bank uses several measures, including the position proxy shown on the right (above), a proxy for risk parity leverage and net debit balances in NYSE margin accounts. All three indicators are low, “creating an asymmetric backdrop where another big decline seems a lot less likely for 2023,” Panigirtzoglou said.

The bottom line, then, is that Armageddon wouldn’t likely be Armageddon. Or at least not according to Panigirtzoglou and JPMorgan, who wrote that, “In all, the risk scenario where the Fed’s policy rate rises to 6.5% might prove less damaging for markets than feared given the very low starting level of demand in both bonds and equities.”

I’m going to recycle some familiar language in the service of reminding readers about what I view as the main risk associated with Fed hikes beyond, say, 5.25%. In the post-Lehman era, market structure optimized around the acronyms (i.e., NIRP, ZIRP and LSAP) and “solved” for the dearth of yield by deploying leverage. The Fed (and its global counterparts) spent a decade forcing every steward of capital to choose between harvesting carry or going out of business, and because that’s not really a choice, everyone ended up short vol in one way or another. Policymakers have to be cognizant of the potential for market “events” (like the LDI implosion in the UK in October) as rates rise further. That’s particularly true considering that quantitative models of all kinds also optimized around a decade of artificial vol suppression, which means that if the Fed pushes the envelope too far, every day will be a multi-sigma day — because the distributions (and thereby the risk parameters) were constructed (and set) based on outcomes that weren’t the result of actual price discovery.

JPMorgan’s Marko Kolanovic is acutely aware of those risks. For those who might’ve missed it, I’ll leave you with his cautionary take from late last month:

The financial system over the past ~15 years evolved around an environment of near-zero interest rates. This includes leverage, functioning of arbitrage channels and strategies that rely on leverage, new models of liquidity provision, liquidity risk of private assets, systematic investing, etc. Together, these can give rise to a self-reinforcing feedback loop of volatility-liquidity-positioning. This type of market interdependencies, which are a feature of financial markets built around a near-zero rate environment, can cause selloffs such as the one at the end of 2018 and on a number of other occasions. These financial risks can lead to contagion and are not captured by low-frequency economics (e.g., ‘Phillips curve,’ etc.). In an environment of deteriorating fundamentals, quantitative tightening and an abrupt increase of interest rates, these risks could emerge much sooner than, for example, an increase in unemployment or decrease in inflation.