Crypto News: 'No recession' sounds great until you think through scenarios

All the chatter of late is about the US avoiding a recession altogether. On the surface that seems like a positive outcome. But when you consider the implications of a 'no landing' scenario, it becomes less appealing because of the risk that a decent recovery turns into an overheated economy and market. It's a recipe for a hard landing for both the economy and asset prices.

Have you heard that the US will avoid a recession in 2023? Well, a lot of people are talking about that possibility, including Federal Reserve Chair Jerome Powell, who said last month that the Fed's own economists have recanted on their view that the US will fall into a recession in 2023.

I am not as quick to turn that way. Plus, I see that outcome as bearish, not bullish. This week's Everything Risk column will explore how I'm thinking about the issue and why that matters for your investment strategy.

First, let me say that my efforts here were inspired by this week's MLIV Pulse survey, which focuses squarely on the potential for an economic soft landing and its impact on assets from stocks to credit. The questions? Is now a good time to invest in the longest-duration bonds? Are US stocks in a bull market, a bear market or a bubble? Share your views here. I'll share mine below.

The Goldilocks narrative today is one that sees ebbing inflation pressures plus softer labor markets ending with the best of all outcomes. In that view, faced with economies that saw inflation running too hot, the US, UK and European central banks abandoned zero-rate policy, cooling inflation and labor markets enough that they can now sit back and watch as the inflation rate falls back to target — all without a costly recession.

That sounds good. And it's an outcome that has the tacit endorsement of Fed Chair Powell. But there are a few problems I see with that narrative -- the first of which comes from the yield curve. Right now, the yield curve is deeply inverted, where you're getting almost 1 ½ percentage points more for 3-month Treasury bills than you do for 10-year Treasury notes. Normally, you'd expect the opposite, with long-term notes carrying higher yields to pay you for the risk of holding that paper for a longer period. But ostensibly, since recession risk says the Fed could be cutting soon, you're willing to get less for 10-year paper.

But how much less? I mean, we're increasingly talking about no recession taking place. And if that's the case, you're going to want to get adequately compensated for taking on the risk of holding long-term debt. We have to expect long-term interest rates to rise a lot if there's a soft landing.

What's more, the Japanese central bank has been at the whole zero-rate thing longer and with greater conviction than any of its peers. And officials there just signaled those days are over, by raising the cap on yields on 10-year government debt to 1%.

My colleague Michael Mackenzie put it this way to me:

The implementation of Japan's yield curve control in 2016 capped the country's 10 year yield at a paltry 0.5%, and spurred waves of cheap money into the global financial system, helping suppress risk premium of international government debt.

But now the days of cheap money may be over — globally. BlackRock's view:

"We see the BOJ's shift confirming why DM yields are likely heading higher as investors demand more term premium for the risk of holding long-term government bonds"

Essentially, investors in long-term bonds haven't been properly compensated for locking up their money for so long. Japanese investors, starved of yield, have helped mightily to keep down that 'term premium' and long-term yields with it. That has benefitted borrowers of all stripes. With the BOJ changing tack, those days may be in the past.

But there are risks closer to home too. For example, a 'no landing' scenario is only possible if people stay employed. In most previous US downturns, it was the cracking of the labor market that ensured a recession. But the US has very few examples in the last 70 years when the unemployment rate was below today's 3.6%. That's great for US workers and worker pay. But, as much as I hate to admit it, it does worry me too. I mean, how much lower can we get the unemployment rate without driving demand higher in a capacity-constrained economy?

When you hear the term 'capacity constraint,' you might think of airlines. There have been stories aplenty of delayed and cancelled flights as carriers deal with a surge in demand with restricted capacity of pilots, flight attendants and air traffic controllers. The period around July 4th was the worst in the US. I sympathize because I had my own nightmarish eight-hour delay getting home this summer from vacation too.

But, there are a lot of other places that feel this impact, such as electric vehicle production, restaurant and hotel staffing, nursing and so on. The risk, then, is that demand outstrips supply and prices rise, bringing the Fed back into the picture with further rate hikes down the line. That's a lot bigger a worry at 3.6% unemployment than it is at, say, 6.6%.

Avoiding recession in 2023 still worries me more than a mild recession because it increases the chance of eventual overheating followed by a hard landing. With unemployment low and the yield curve deeply inverted, the lack of an economic release valve presents multiple tail risks.

3.5%

Initial GDPNow 2023 Q3 forecast

Luckily, I think the economy is softening just enough to prevent overheating and a hard landing. You wouldn't know it from the initial 3.5% forecast put out by the Atlanta Fed for this quarter's growth. But on Monday, the Fed's senior loan officer survey on bank-lending practices came out and it was an eye-opener as far as how much credit is tightening.

Here's the link. I did a search for "loose" or "loosening" to see if there were more favorable lending conditions anywhere. There weren't. The terms never came up once in the survey. But the word "tight" appears 66 times. That tells you credit conditions are tightening everywhere, for every kind of loan, and for both businesses and households.

So when Powell says he thinks there is more transmission of the Fed's tightening in the pipeline, this is what he means. The question isn't whether that tightening leads to a slowing that's not yet apparent. It's how much slowing we get.

For example, look at how Bloomberg US economists Anna Wong, Stuart Paul and Jonathan Church started their most recent preview of the US labor market:

Two months before the start of a recession in December 2007, the consensus was that the economy would have a soft landing from the housing bubble — even the Fed chairman and staff thought so. Most economic data had surprised on the upside — with the exception of the Senior Loan Officer Opinion Survey (Mon.) — and the housing market had stabilized. We know how that turned out.

Point taken. The economy looks robust right until the very end. But the cracks underneath right now are already visible. I've talked before about Black and Hispanic unemployment rising and the loss of temp jobs. But the Bloomberg economists put the weaknesses today very clearly at the center of what's driving inflation down:

...there are real cracks in the economy. Long after supply chains have normalized, it's a downdraft in demand that's driving the current wave of disinflation.

What's clear in all this is that the Fed isn't cutting rates anytime soon. So short-term rates won't go anywhere. But until the cracks in the labor market become undeniable, that means pressure on long-term term rates until something gives way. Let's look at how this soft/no landing scenario affects asset prices.

Take housing for example. Lots of homeowners want to move. They just can't. Their low mortgage rates lock them into place. That means there's not enough supply on the market, driving up prices. Only 20% of mortgaged homes meet the criteria of a 5% mortgage rate, increasingly seen as the tipping point to unlock supply. Homeowners with mortgages above that rate are twice as likely to move as those below it.

This is an unstable equilibrium that — unless the economy has a mild recession and the Fed cuts — can only be broken by an increase in interest rates. And mind you, higher interest rates mean fewer homeowners are at the tipping point where moving makes sense economically. The higher rates will just drive down demand to meet that dwindling supply. The risk, of course, is a crash landing for residential housing to add to the mounting nasty unwind in commercial real estate.

Long-term Treasury holders will certainly feel some pain if this goes on for much longer. Unless there is an economic release valve, expect bond holders to demand compensation for holding long-term paper. With short rates pinned above 5%, that will cause significant pain as the rate gap closes between 3-month Treasury debt and 10-year paper.

So, a `no landing' scenario is one that risks a decline in residential property prices and hurts bond investors. Adding in the woes of commercial real estate, a hard landing for the economy would be unavoidable. Equities can continue to climb as long as earnings hold up. But, of course, a hard landing economically would mean a hard landing for earnings too.

This is why a mild recession is preferable to no recession, where the risk is an even worse recession down the line. I think more people agree with me than are willing to admit it. That's one reason the yield curve is so inverted right now. But you can't put your head in the sand and miss out on a monster rally, like we've seen in US equities, particularly technology shares.

This is not a fundamentals-driven rally. It's driven by people who were caught wrong-footed by the US economy's resilience and are afraid of missing out and underperforming. Their catch-up is driving shares even higher.

In the meantime, labor-market data could be the biggest market movers — job openings on Tuesday, the ADP report Wednesday, jobless claims on Thursday and the monthly US jobs report on Friday. Expect markets to rally on any soft data because the prevailing narrative is now about a soft landing. And soft data will validate that view.

But as Matt Maley of Miller Tabak puts it:

"Investors need to be careful about trying to squeeze every last penny out of this rally in the stock market over the coming days and weeks given that many of the best stocks are quite expensive."

Caveat Emptor.

We think the Fed may be misreading the economy's strength based on low unemployment: That shouldn't be taken as the usual sign of a buoyant economy, but rather a result of structural worker shortages holding back growth potential. We think this perceived strength raises the risk that the Fed hikes more than markets expect and then cuts as it generates too much weakness – rather than just holding tight.

Jean Boivin

Head, BlackRock
Investment Institute

Weekly commentary, July 31

Thinking about moving to Miami and afraid of hurricanes? Mount Trashmore is perhaps a bigger concern.
Speaking of the environment, extreme heat and aging power grids aren't a good combination.
China won't be able to bail out global growth. Its own miracle growth story is ending.
Morgan Stanley's Mike Wilson has stuck to his call for a pullback in the S&P 500 by year-end, even as the market has surged.
Elon Musk has become a liability to Tesla's EV brand dominance.

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