In the latest edition of the Weekly, I suggested the unofficial consensus is still that the US economy will succumb to a recession one way or another.

Either the labor market and spending will prove too resilient, imperiling the inflation fight and forcing the Fed to turn the screws until “something breaks,” or the drag from tightening already delivered will finally manifest in a significant slowdown. Either way, a soft landing is exceedingly unlikely. Or so goes one narrative.

Among market observers who are tentatively on board with some version of the soft landing story, there’s ostensible tension between relatively upbeat expectations for the world’s largest economy and the scope of Fed cuts priced into 2024 by traders.

Note I said “ostensible” tension. Market pricing points to ~four quarter-point rate cuts next year. That’s not infeasible. And it’s not necessarily inconsistent with a resilient economy. Here’s why:

1. Rightly or wrongly, Fed officials buy into the idea that not cutting rates in the face of lower realized inflation outcomes is tantamount to countenancing passive tightening through the real policy rate channel. Multiple officials, including Jerome Powell, have raised the issue themselves or at least addressed it when someone else broached the subject in their presence. “Insurance cuts” to prevent passive tightening are all but a foregone conclusion assuming core inflation continues to moderate. Depending on your forecast for the trajectory of core price growth in 2024, you could easily get to two quarter-point rate cuts just based on the mechanical read-through of receding inflation for a static real policy rate. Nothing to do with recession.
2. Market participants may harbor a misconception about the bar for rate cuts. The accepted narrative says a Fed still suffering from PTSD will be reluctant to cut rates even in the presence of softer data, including hypothetical job losses. It could actually be the other way around. With rates at 22-year highs and the Fed convinced that eventually, monetary restraint will work to slow demand, they may be quicker to cut rates out of concern that when the impact of the hikes already delivered finally does hit the economy, the fallout could be swift and dramatic given the scope and rapidity of those hikes.

Between those two considerations, it’s not far-fetched at all to project four rate cuts for 2024, even absent a recession.

Indeed, even Goldman’s rates team was compelled on Friday to concede that 100bps of cuts isn’t out of the question despite the bank’s house call for just one lonely cut and not until Q4 of next year.

“This degree of easing in 2024 appears inconsistent with our economists’ view of a soft landing, and is perhaps somewhat excessive even when considering the distribution of risks around our economic outlook [but] at this point we don’t yet see enough asymmetry in year-end 2024 pricing to engage in outright shorts,” the bank’s Praveen Korapaty said, commenting on the additional 40bps of rate cuts priced into 2024 on top of the 60bps priced as of late last month.

“While we see these cuts as too aggressive in both expected terms and under our modal scenario, the easing currently priced is not inconceivable in some states of the world,” Korapaty went on, noting that a recession could “trigger even more aggressive cuts than priced” while insurance cuts commencing mid-year are also possible in the event inflation recedes quicker than the bank expects.

For some, this is all too much to bear (no pun intended), particularly as the “soft landing plus insurance cuts” story is beginning to manifest in risky wagers. The move in the Russell 2000 and massive inflows over the past two weeks to junk bond funds prompted exasperated derision from some corners.

It’s one thing if big tech rallies on receding bond yields. That’s seen as “fair” given that the mega-caps’ “quality” characteristics can shield them in the event the economy goes south. A mammoth rally for small-caps and a tsunami of inflows to high yield credit, on the other hand, is viewed by some as an expression of irrational faith in an “immaculate” resolution to the most vexing macroeconomic environment in a generation.

Please understand: There’s more to the price action than meets the eye. It’s not, as one CIO suggested in remarks to Bloomberg, as simple as investors waking up one day and going “all in” on “the things that they had complete disdain for two or three weeks ago.”

As Nomura’s Charlie McElligott noted, a lot of what you saw this week was a “violent covering unwind.” Everything “low quality” (where that means unprofitable companies, corporates with steep maturity walls and so on), as well as all things related to the credit cycle, were crowded shorts.

The Russell saw a spot up, vol up dynamic post-CPI. It was a “panic grab into both ‘chase-y’ upside and new downside hedges as index blows into a wider distribution,” McElligott said, adding that the price action “continues to display the ugly truth behind a massive beta rally in a world where few, if any, institutional investors had enough net exposure on, which was largely a function of having too grossed-up short books.”

The Russell outperformed big tech by an anomalous margin this week. That’s not entirely (or even primarily) a function of any wholesale rethink in the outlook for the US economy.

In any event, this’ll continue to be a tightrope walk for the foreseeable future. When it comes to market pricing for the Fed, Goldman suggested that anything beyond the current 100bps of easing tipped for 2024 would be a fade unless accompanied by evidence of a looming recession.

“For cut pricing to extend further, we might need to see continued softness in the data,” Korapaty wrote. Of course, “continued softness in the data” would call into question bullish bets on economically sensitive equities, high yield credit and so on.

BofA’s Michael Hartnett made the same general point. “5% to 4% bond yields = easier financial conditions = bullish risk. 4% to 3% yields = recession = bearish risk,” he said.