NEW YORK: Markets have been trading as if the end of the world is at hand. But what most participants see, behind the recent financial turmoil and contagion fears, is a still-strong US economy, the MLIV Pulse survey shows.
The collapse of three US banks and the scramble to rescue others, including Europe’s Credit Suisse Group AG and First Republic Bank, sent stocks and bond yields plunging.
Bets on Federal Reserve (Fed) monetary tightening have been dialed back, swap contracts reflect expectations for rate cuts within months, and recession warnings are being ramped up.
Yet the world foreseen in those trades is hard to square with the one outlined by 519 investors, retail and professionals, who took part in the MLIV survey between March 13 and 17.
Most respondents believe that a hard landing will be averted, with about two thirds predicting that the US economy is either heading towards a soft landing, accelerating or cruising.
Most lean towards a scenario in which the Fed ekes out some more rate hikes, to bring inflation closer to target.
The survey findings suggest a mismatch between what investors see as the likely economic outcomes, and the direction that trades have taken – driven by market momentum and concern about banking troubles.
“The thing about contagion risk is, it’s really about the spread of irrational fear,” said Greg Peters, co-chief investment officer of fixed income at PGIM.
The Swiss National Bank’s pledge of support for Credit Suisse helped calm the chaos. And the European Central Bank (ECB), which went ahead as planned with a half-point increase in interest rates last Thursday, suggested inflation-fighting hasn’t moved to the back burner for central banks – even though the ECB avoided signalling what comes next.
This week it’s the Fed’s turn. The US central bank still enjoys investor confidence, according to the MLIV survey. More than 60% of retail and professional investors alike said it hasn’t lost credibility.
Investors see tomorrow’s decision as being between a pause on financial stability concerns and a quarter-point hike to continue the inflation-busting campaign.
One key question is how much of the Fed’s desired financial tightening will now happen as a result of banks turning cautious.
Credit spreads are an important channel through which market distress affects the real economy.
So far, they haven’t widened to a degree that implies a significant slowdown.
Goldman Sachs Group Inc economists estimate the likely impact of tighter lending conditions at up to 0.5% of US gross domestic product.
The banking turmoil has clearly had a psychological impact, as well as shifting the Fed outlook. Almost half of MLIV respondents said a 50-point hike, the base case not long ago, would add to financial system risks after the collapse of Silicon Valley Bank, the biggest US bank failure since the 2008 aftermath.
“The Fed is still on a long-run path of tightening policy to bring inflation down,” said Darrell Duffie, a Stanford University finance professor.
“The most likely path for the Fed is that there’s a temporary pause in rates, maybe just until the next meeting after this coming one, and then the Fed would resume as dictated by data on inflation concerns.”
For the Fed, a big real-economy shock stemming from this month’s financial events is a risk, not a foregone outcome or even a likely one, while persistently high inflation is a fact, one that policymakers have battled against for a year with little progress to show so far.
So even if the US central bank chooses to pause this week, it could be a hawkish pause, one that allows markets to stabilise but increases the risk of more hikes to come.
Fed officials have flagged the hiring boom and rising wages as one of the main inflationary threats.
A majority of MLIV respondents said the jobs market is either softening already or will do so soon.
Roughly one-third said that the shortage of workers means there may not be much cooling this year, and that higher rates will instead compress profit margins.
The Bloomberg Economics view is that a soft landing remains an outside bet, with a 75% chance of recession in the third quarter of this year. Fed hikes have in the past mostly ended up breaking things, and this cycle is likely to be no exception.
That’s broadly the signal sent by plunging yields in the past week, according to Matthew McLennan, co-head of the global value team at First Eagle Investment Management.
“The bond market is telling you that the last block has been taken out of the Jenga stack by the Fed,” he said.
“After all the banking stress, lending growth will probably slow, which raises the probability that nominal growth slows. You can see how this could translate to a recession.” — Bloomberg
