By Anwiti Bahuguna, Ph.D., Senior Portfolio Manager, Head of Multi-Asset Strategy

The Fed is taking a potentially aggressive course in an effort to control inflation. Investors fear a recession is looming.

The Fed Gets real over inflation

Over the past two years, inflation has been a bogeyman for markets – higher and stickier than expected. To combat higher-than-expected inflation, the Fed has telegraphed an aggressive stance on raising the fed funds rate. Markets now expect nine hikes, taking the central bank’s overnight rate to 2.00%-2.25% by the end of 2022.

Recession fears rise

Recession fears grabbed the headlines when the yield on 2-year treasuries briefly exceeded that of 10-year treasuries. Historically, some yield curve inversions have presaged a recession.

But a single inversion of the yield curve is on its own an imperfect recession predictor: an inversion may precede a recession, but not all inversions lead to a recession. Looking at the economy more broadly, we believe that while fundamentals remain strong, particularly the labor market, the list of risks to growth is growing, including the end of fiscal and monetary stimulus, sanctions against Russia and the war in Ukraine.

With this heightened concern about the recession, it is important to recognize that not all recessions are the same. They have different factors, which can impact their duration and severity.

In the current environment, calibrating monetary policy with enough precision to slow growth but not cause a slowdown is a significant challenge for central banks given the relatively rudimentary tools at their disposal. Investors may worry that policymakers will catch up and end up tightening interest rates well beyond what the economy can handle.

Risky assets can still do well, even when the yield curve is right

We looked at how stocks tend to behave between yield curve inversions and the onset of a recession (when one has happened). And although there are only a limited number of time periods to consider, we have seen stocks rise frequently, and sometimes quite sharply.

Bottom Line: plot the course from here

Given the macroeconomic headwinds, we expect growth to slow to “near-trend” levels this year from the very strong growth rate of 2021. In fact, Q1 GDP figures released late April showed an unexpected decline of 1.4%, but that was mainly due to technical factors and not necessarily recessive. Underlying trend growth, as measured by private domestic demand, has been solid and still above trend. But in the coming quarters, rising rates and falling real incomes could weigh on consumer spending and lead to a further slowdown. Our base case is that we avoid recession, but the risks are increasing.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.