Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, March 27, 2023.
Brendan McDermid | Reuters
Investors are too confident the Federal Reserve will cut interest rates this year and could pay the price later, according to asset management giant BlackRock and others on Wall Street.
Market pricing as of Tuesday morning pointed to the Fed holding its benchmark interest rate at current levels and then starting to reduce as early as July, according to CME Group calculations. Those cuts could total as much as a full percentage point by the end of the year, the firm’s FedWatch gauge shows.
That comes despite multiple public statements from central bank officials, who indicated in their “dot plot” unofficial forecast last week that they see probably another quarter percentage point hike and then no cuts at least through the end of 2023.
The expectation for cuts would be consistent with a recession and an accompanying fall in inflation, assumptions that Wall Street strategists think are dubious.
“We don’t see rate cuts this year – that’s the old playbook when central banks would rush to rescue the economy as recession hit,” BlackRock said in its weekly client note. “Now they’re causing the recession to fight sticky inflation and that makes rate cuts unlikely, in our view.”
The investing implications are ominous: BlackRock, which manages about $10 trillion in client money, says it is underweight stocks in developed markets such as the U.S. Instead, it recommends clients focus on investments like fixed income that is indexed to inflation, as well as very short-duration government bonds.
Resilience in stocks, the firm said, is coming largely because markets are still holding onto hope that the Fed starts to ease after a year of tightening that sent the benchmark federal funds rate up 4.75 percentage points.
“We think the Fed could only deliver the rate cuts priced in by markets if a more serious credit crunch took hold and caused an even deeper recession than we expect,” BlackRock strategists wrote.
A slowing economy with high inflation
Projections the Fed released following its latest rate hike last Wednesday imply a shallow recession for later this year.
The median expectation for gross domestic product growth for the full year is 0.4%. Considering that the first quarter gain is tracking, according to an Atlanta Fed gauge, at 3.2%, the math would require at least some negative growth the rest of the way to get to the 0.4% estimate.
At the same time, officials estimate a 4.5% unemployment rate by the end of the year, from the current 3.6%. Getting there would require a loss of more than 571,000 jobs, according to an Atlanta Fed calculator.
Though that would be challenging, the Fed is likely to prioritize its inflation fight, particularly if the data continue to indicate elevated prices, Citigroup economist Andrew Hollenhorst wrote.
“Financial stability concerns are likely to remain at least somewhat elevated over the next few months. That means a more cautious Fed and markets pricing a higher probability of more dovish policy outcomes,” Hollenhorst said. “But to the extent financial sector risks do not materialize, focus will gradually shift back to inflation.”
Bank of America analysts note the paradox of investors simultaneously pricing in a Fed that will relax policy to fight an economic slowdown while also betting that stocks will continue to climb.
“The major US equity indices seem to be looking past the type of shock or economic slowdown that would get the Fed to cut rates, and yet are trading on expectations of a lower (eventually) discount factor,” BofA said. “This is despite two important facts: (i) recessions are reliably negative for equities throughout history and not discounted in advance, and (ii) the FOMC projections and dots imply no rate cuts even if we get a mild recession this year.”
Like BlackRock, Bank of America is advising clients to bet against U.S. stocks and instead focus on strategies that pay when the market falls.