Is a U.S. recession inevitable? Powell’s Congress address sparks concern among investors

The probability of a recession in the United States has increased after Federal Reserve Chair Jay Powell addressed Congress. Powell’s comments reminded investors that inflation remains a persistent threat. This led to both stocks and bonds selling off, with major indices ending the week underwater. The market now expects the Fed to lift its benchmark rate 50 basis points at the next meeting, with bonds and derivatives pricing in a more hawkish outcome. The yield on the US 2-year Treasury-Note has surged 18 basis points since Monday’s settlement to 5.06%, the highest level since 2007. It has also deepened its inversion over the 10-year yield to negative 108 basis points, the highest since the early 1980s.

Under normal conditions, longer-term loans or bonds, which carry higher risks, are expected to have more expensive interest rates than their shorter-term counterparts. However, when the Fed starts tightening borrowing conditions by lifting short-term rates to restrict credit creation and eventually choke off growth, this changes. While the magnitude of a yield curve inversion is not necessarily predictive of a deeper or longer recession, a host of other bond market indicators are sounding alarm bells.

Alfonso Peccatiello, the former bond trader and CEO of TheMacroCompass.com, noted that the bond market expects the Fed to remain tight and fight inflation, with interest rates likely to remain above 5% a year from now. He believes that cannot happen if a recession is unfolding, as the Federal Reserve will be forced to cut interest rates. Peccatiello warned that the tighter the borrowing conditions for the private sector, the higher mortgage and corporate borrowing rates will be, which raises the risk of freezing credit markets and, in general, accelerating a recession.

Peccatiello expects stocks to suffer from an earnings recession, which is not fully priced in, before the Fed delivers relief in the form of rate cuts. An earnings recession is marked by two consecutive quarterly declines in S&P 500 earnings, which often, but not always, precedes an economic recession. He believes that the U.S. is already in an earnings recession, with stocks reflecting complacency. However, Peccatiello does not expect a disaster, and he sees about 10% maximum downside risk in the S&P 500 down to the 3600 level, which is around last year’s lows. He adds that the stock market generally bottoms before earnings bottom, as the Fed historically capitulates and slashes rates when earnings drop. This results in better stock valuations, which eventually halt the decline in stock prices and signal the start of a new bull market.

In conclusion, Powell’s comments have increased the chances of a recession in the United States. The bond market is sounding alarm bells, and Peccatiello warns that a tighter borrowing environment for the private sector could lead to credit market freezes and accelerate a recession. An earnings recession, which is not fully priced in, could cause stocks to suffer before the Fed delivers relief in the form of rate cuts. However, Peccatiello does not expect a disaster and sees the maximum downside risk in the S&P 500 at around 10%.