Investors are making the wrong bet on a recession — and it's going to cost them big time

Given that popularity, it's important in the economic-forecasting business to pick your battles with it wisely. That said, it's also important to acknowledge when the bond market is off base, because when the market's expectations run into a vastly different reality, things tend to go haywire — and investors can lose (or make) a lot of money depending on how they're positioned. And it's becoming increasingly clear that the bond market is reading the economic tea leaves all wrong.

Right now, the bond market suggests that the economy is on the verge of a hard stop and a recession that will force the Federal Reserve to cut interest rates to stimulate activity. Actual economic data, on the other hand, points to hardly gangbusters but continued growth for the US. And the longer the market expectation diverges from the economic reality, the more painful the market adjustment will be once it happens.

What the markets are expecting

There is no doubt that the bond market can be an important indicator of where things are going, but it's not infallible. There's already been evidence of its fickle nature earlier this year. Based on the yields of various government bonds, it's possible to determine investors' general consensus about what the Federal Reserve is going to do next — raise, cut, or hold interest rates steady. At the start of 2023, bonds indicated that the Fed would hike interest rates a single time this year — a cumulative 0.25% increase. As the economy showed signs of stronger growth in January and February, the market swerved and suggested that the Fed would need to hike four times to slow activity and inflation — a 1% total increase in the benchmark rate. But after the Silicon Valley Bank collapse and concerns about a lending crunch, the bond market was pricing in three Fed interest rate cuts for a cumulative 0.75% decrease by the end of the year. We're at two cuts now, but it is still a remarkable reversal.

For this consensus to come true, the recent shakiness in the banking system would need to turn into a full-blown credit crisis that brings about an imminent recession. Investors and economists concerned with this possibility have in recent weeks pointed to data showing that people are pulling their money from banks, lenders are getting more particular about who they extend loans to, and that there's been a collapse in commercial real-estate valuations.

On the economic side, the bond market view would probably look something like the Fed's latest GDP projections. The Fed's outlook expects real GDP to advance just 0.4% this year. But how is that shaping up right now? Current estimates put GDP growth for the first quarter of the year at a 2% annualized rate. That means for GDP to sink to 0.4% growth for the entire year, the economy would have to shrink in each of the next three quarters to meet the final estimate. This would be a sudden stop for the economy and have cascading effects for the labor market and consumers. In this scenario, for example, the Fed forecasts a jump in the unemployment rate to 4.5%, which means over 1.6 million people would lose their jobs.

As for markets, this kind of jolt would be particularly jarring. Stocks are pricing in some earnings recovery and a generally strong economy. US indexes are up about 10% over the past six months, while markets in Europe are up even more. So if the bond market ends up being right about the economy, there would be a serious, ugly wake-up call for the stock market.

Given how gloomy the outlook among bond-market investors is, the bar is not especially high for them to be surprised. The economy does not need to defy gravity, it just needs to tread water. And if conditions hold up, the consensus is seriously off base.

What the economy is showing

While the bond market warns of a collapse, the actual economic data is sending very different signals. Business investment is sluggish but has not been much of a growth driver to begin with, and consumer demand is holding steady. In spite of high-profile layoff headlines, thelabor market remains historically strong, even as wage growth cools. A recession should not be ruled out completely — after all, the Fed believes higher unemployment is one way to bring inflation under control. But the time to be most concerned about recession was last year, when residential investment was collapsing, global growth was tumbling, and energy prices were surging. Nowadays, most of the headwinds are abating:

• The drop in mortgage rates earlier this year has already lifted housing-market activity. Builders have sold homes that they've yet to start, indicating more construction on the way.
• Global growth is not as bad as it was in 2022. Europe was worried about keeping the heat on, the UK had a blowup with its pensions, and China was tightening its regulatory environment. Today, conditions are not great, but it's obvious they've gotten better, not worse.
• Energy inflation has slowed notably from last year. This will be reflected in household utility bills, which will support household incomes.

And as for fears of a "credit crunch" triggered by bank instability, I think there are a few important things to point out. First off, there is no middle ground in a banking crisis — it either happens or it doesn't. So far, signs point to no crisis: After a brief period of volatility, deposits in the banking system appear to have stabilized. As for the downstream loan "crunch," the evidence is also lacking. Credit standards and core bank lending were already slowing over the past several quarters, so the tightening doesn't come as some great shock. In fact, bank lending as a percent of US GDP is essentially unchanged since 2016 — this would suggest that the US economy is not nearly as sensitive to shifts in the availability of credit as is thought.

Second, increasing housing activity has brought prospective borrowers back into the market for mortgage loans, and banks are extending those loans — hardly the sign of a cataclysmic credit stoppage. Indeed, homebuilding stocks have been breaking out to fresh highs.

Two roads diverged

Today, predicting a recession means relying on a select few signals to justify your call. I don't think the Wall Street aphorism about the bond market being "right" holds up this time. As I mentioned, the consensus assumes a sudden stop in the economy, so even if conditions are just OK for the economy, the divergence with the baseline could cause a serious market mess.

According to the S&P Global's Monthly US GDP measure, real growth advanced 4.5% in January and 2.8% in February. Assuming that the Fed is serious in its commitment to stomping out inflation, then a period of below-potential growth would be necessary to bring inflation down in line with the central bank's goals. The current data suggest the economy is running slightly above potential — which is not welcome news for a central bank trying to bring down inflation. In fact, there is some evidence that conditions might actually pick up in certain areas. Manufacturing is a good example: The value of the dollar has dropped, making it cheaper for American companies to export their goods abroad, and global growth has strengthened, so there are more overseas customers ready to buy.

The Fed slowed down its interest-rate increases because of the SVB disaster in March, and I suspect they will pause completely at the June meeting to signal that they're taking an extra-cautious approach to the financial-system mess. But if the economy ends up holding up relative to expectations, the Fed's job may not be over. Instead of the interest-rate cuts that the bond market is pricing in, the central bank may be forced to restart rate hikes later in the year to cool off any fears of inflation kicking back up.

If the Fed hikes rates again, the resetting of expectations would slam markets. For stocks, the hope for lower interest rates would be dashed, and there could be a sizable drop as the new reality takes hold. But the stronger economy could provide a cushion, since higher consumer demand would help keep profit expectations afloat. On the other hand, the bond market would take it squarely on the chin. A sudden expectation shift from a weaker economy and lower interest rates to a stronger, high-interest-rate environment would send yields soaring and bond prices tumbling. And the longer investors hold on to the idea of rate cuts, the worse the eventual dislocation will be.

I think the Fed wants to give the economy the benefit of the doubt. After all, they've been underestimating inflation and employment for the better part of the last year. The bond market, however, does not give the economy the benefit of the doubt. And the current mismatch could lead to serious market chaos and investor pain down the road.

Neil Dutta is head of economics at Renaissance Macro Research.