The Recession Trade Returns to Wall Street

As the Federal Reserve's aggressive rate hikes continue, investors are increasingly focusing on the potential impact on the U.S. economy and the stock market. The recent rally in stocks, fueled by optimism about slowing inflation, may be short-lived as concerns about a recession resurface. The Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all experienced losses last week, with the Nasdaq's 1.6% decline being particularly notable after its strong rally the previous week.



The market's reaction to stronger-than-expected retail sales data and comments from Fed speakers suggests that investors are becoming more cautious about the economic outlook. St. Louis Fed governor James Bullard's statement that rates may need to rise as high as 7% to combat inflation was met with a brief market sell-off, but the S&P 500 managed to close the day down just 0.3%. This resilience may indicate that the market is becoming less sensitive to the Fed's hawkish rhetoric.

However, the market's focus on real rates as the primary driver of stock prices has started to shift. Since October 12, credit spreads—the difference between yields on corporate and government bonds—have been the largest driver of stock prices, according to Quant Insight's models. This shift reflects the market's growing concern about the potential for a recession, as the inverted yield curve and widening spread between three-month and 10-year Treasuries suggest.

Despite these signs, the market does not appear to be overly concerned about a recession just yet. The spread between Treasuries and junk bonds has narrowed, and the market for CCC-rated bonds, the riskiest segment of the junk bond market, has remained relatively stable. However, Michael Darda, chief strategist at MKM Partners, warns that the market could be foreshadowing broader credit market weakness in the future.

As the market awaits the release of November's consumer price index and the Fed's likely rate hike in mid-December, investors should be prepared for increased volatility and uncertainty. The stock market's recent rally may continue in the short term, but the potential for a recession could make the market's trajectory more unpredictable as the year progresses.



In conclusion, the recession trade has returned to Wall Street as investors grapple with the potential impact of the Fed's rate hikes on the U.S. economy. While the market has shown resilience in the face of hawkish Fed rhetoric, the shift in market drivers and signs of a potential recession suggest that investors should remain vigilant and prepared for increased volatility in the coming months.