“Bonds imply a recession.”

So said JPMorgan analysts led by Marko Kolanovic, who’s maintaining a modest Overweight in bonds and cash, set against an Underweight in risk.

As most readers are doubtlessly aware, markets and the Fed aren’t aligned on the odds of rate cuts in 2023. Simply put: Markets suspect the odds are elevated and the Fed insists the odds are de minimis.

That juxtaposition is a product of disagreement between policymakers and traders on recession probabilities. On that front too, markets suspect the odds are elevated and the Fed, while willing to concede the risk, insists the odds of a deep recession are very low. (Even as staff predicted a shallow recession at the March FOMC meeting.)

“There are only two outcomes after the end of a hiking cycle — recession or soft landing,” Kolanovic gently reminded market participants. “Comparing current OIS pricing to average behavior in these two scenarios [shows] the market is much closer to the recession outcome.”

Given how fluid the macro situation is, JPMorgan seems more comfortable with their cash Overweight than anything else. The bank is certainly skeptical of equities, but turning even more bullish on duration could be perilous too given the recent rally and the sheer amount of ambiguity about what’s coming next for jobs, wages, inflation and geopolitics.

The point of the visual is clear enough: If the US economy isn’t headed for a recession, then market pricing is severely offside, and I’d add that if current market pricing does overstate the odds of a downturn, that could be bad news for equities too given what it’d imply for rates and, more to the point, tech valuations.

Speaking to the risk premia debate, Marko noted that “a mediocre premium can be tolerable with low volatility [but] this is a case where the risk numbers are not to be trusted.”

Why? Well, because vol is being tamped down by dynamics which many argue are artificial, specifically the 0DTE options phenomenon which is manifesting in intraday reversal behavior and the suppression of realized vol. That vol suppression feeds on itself and can be conducive to a “stability breeds instability” setup.

Kolanovic again drew a parallel with early 2018, noting that it was yield curve steepening which helped trigger the implosion of the VIX ETN complex (some of the macro data was heating up at the time, and traders were hit with a hot average hourly earnings print the Friday before Volmageddon).

This time around, Marko said we could see a kind of mirror image of 2018, where an abrupt slowdown triggers a bull steepener which serves as the proverbial skier’s scream that triggers an avalanche — a “rude awakening,” as he put it.

“While the mechanics of the trade are different, it can likely play out the same way with a bull steepening this time around as late-cycle risks finally materialize, rather than the bear steepening of 2018,” he wrote, adding that “unattractive risk premia and recession risks continue to steer us to cash, and the coming volatility flare-ups will undermine the tenuous setup for risk assets.”