One big risk in 2023 is that a hard landing doesn’t happen.
That’s counterintuitive and it’s an oversimplification, but it encapsulates a scenario some worry is underappreciated and also mispriced.
The market still expects Fed cuts in the back half of next year, a notion officials have repeatedly suggested is misguided. The Fed hasn’t yet resorted to the kind of explicit rebuke the Bank of England delivered in November, when both the policy statement and Andrew Bailey flat out said market pricing was wrong. Of course, in that scenario, policymakers were pushing back against hawkish bets, whereas the Fed wants to disabuse traders of the dovish muscle memory behind pricing for at least two 25bps cuts by this time next year (figure below).
Jerome Powell could, if he chose, be more adamant about the Fed’s intentions to keep rates at or above 5% once the peak is reached. He’d argue officials have been as explicit as they can be, but the Fed hasn’t pushed back forcefully enough to make a believer of STIRs. The irony is that the harder Powell pushes on that point without physically pounding the table (or the lectern), the higher the odds of recession in traders’ minds and thereby the more rate cuts they’ll be inclined to price.
Arguably, Powell should publicly rule out a recession in 2023 (as foolhardy as that’d be) not because he believes a downturn is impossible, but because suggesting as much would be the only way to compel traders to stop betting on rate cuts.
The problem isn’t so much the market’s concerns about the lagged impact of 2022’s rate hikes. Rather, the issue is the market’s apparent assumption that any additional Fed hikes are guaranteed to result in a quick, clean recession, where “clean” just means an unequivocal downturn that checks all the boxes, and thereby hands Powell all the plausible deniability he needs to execute an equally “clean” pivot.
But all Larry Summers Wile E. Coyote references aside, the convoluted macro backdrop may continue to manifest in contradictions and mixed signals from the world’s largest economy, in which case the Fed will find it easy to pause but very hard (if not impossible) to pivot.
In a Tuesday note, Nomura’s Charlie McElligott flagged that as a potential “surprise” in 2023, not to the extent nobody sees it coming necessarily, but in that it isn’t priced and would be disappointing for markets expecting a more linear outcome.
“Everybody sees the housing and manufacturing recessions within the US economy happening in real-time, along with the clear cooldown in goods inflation [but] a tight labor market and stubborn core services prices” may mean the “higher for longer” narrative emanating from policymakers just “doesn’t quite go away,” he said, adding that “equities and bond markets want a hard and fast recession, which allows for a tidy pivot by H2 2023.”
That “tidy pivot” is reflected in market pricing, but certainly not in the Fed dots. Or at least not until 2024. Hence the risk mentioned here at the outset: No one wants a crash landing, but you could argue that markets do want a hard landing, or at least a landing that’s bumpy enough to shake the Fed out of its Volcker impression.
“A clean breakdown into recession keeps getting delayed [and] this uncomfortable tension can continue,” McElligott went on to say. “Thus I think the largest surprise potential would be that the economy keeps ‘holding in’ [and] those second-half Fed cuts get pushed back into 2024 instead.”
That outcome, Charlie remarked, could be “really painful for a market trying to equate ‘pause’ with ‘pivot.'”
Yes, indeed, Walt (and Charlie). That would be painful, an extended discomfort for a market that likely will be anxious to pivot and move on.
“equities and bond markets want a hard and fast recession, which allows for a tidy pivot by H2 2023.”
We want neat and tidy, not complicated and messy.
Some of us “wes” may want what you suggest, but certainly not all. Those among the 8k layoffs at Goldman, along with those suffering bonus cuts, certainly won’t appreciate their losses. And a few million other “Joes” who will be out of work can’t last that quick year of pain. Every time I hear stuff about needing some real pain to reset the system, I hear some damn general saying something about acceptable losses of 10 or 15% of his troops for the “greater good.” Ask those dead soldiers if the loss was acceptable to them. If we ran the system better maybe so many Joes wouldn’t have to suffer so much. Remember the 90%, not a trivial number, btw, are the ones who will get that recession we think is OK in their necks, not us in the 10%.
Cool insight, hadn’t even considered that.
I think a divided Congress causing the usual underspending will make a recession more likely though, right?
I can’t think of a worse scenario for 2023. That doesn’t involve dystopia, cannibalism, etc.
The markets are going to have a rough time- stimulus is being withdrawn both fiscal and monetary- but that is the least of it. Corporate profits are stretched, and there is a lack of healthy growth from an increasing working age population, and lack of productivity- that is the real economy will be struggling with structural problems. Hard for the financial markets to get out of the way of those problems. That does not even get to the economic war between the west and Russia/China axis. Challenging times.
Clogged transmission channel runs both ways…
Simplistically, I think the longer you expect the economic slowing to last, the more you lean toward fixed income and away from equities.
It is ironically funny if you think about it, if we get a hard landing the market might crash down 15%+ from here and then start to recover after a Fed pivot, higher for longer probably means market grinds down 10%+ from here till end of 2023, both scenarios could have indices at roughly the same level December of next year, but the feeling would be completely different.