A Recession Could Cure This Economy

Michael Hartnett has his eyes on 10-year bond yields...

Hartnett is a strategist at Bank of America (BAC). In his view, as long as long-term yields stay below 5%, the market should more or less stay put.

This year, 10-year yields started out around 3.8%... already about as high as they'd been since right after the Great Recession.

As the Federal Reserve kept raising interest rates, the 10-year yield rose to a 16-year high of 4.8%. While it hasn't crossed 5% yet, it's not far off.

Until it crosses that 5% threshold, Hartnett doesn't expect a meaningful sell-off from the S&P 500.

On the surface, it sounds like investors can breathe a sigh of relief... for now. But it's not great if we want to put the current market environment behind us.

As we'll explain today, our economy needs a reset of some sort. The market stalling out won't provide that.

Investors have been set on the 'soft landing' story for a while...

As we wrote earlier this month, we don't expect it to play out the way they hoped... and that's good.

The market thinks it wants a controlled and moderate slowdown that doesn't push us into a recession. This scenario would be great for investors in the short term. Stocks wouldn't drop as much.

However, a soft landing won't be the end of the story. If the economy never shrinks, then the Fed is never going to lower interest rates.

Remember, interest rates act as a tax on the economy. Their primary purpose is to temper economic activity.

Fed Chair Jerome Powell has been clear that he's prepared to raise rates. He'll keep them high for as long as it takes to completely wipe out inflation.

And Bank of America's Hartnett agrees with the strategy. He views a recession as a necessary "reset" for the economy... one that will allow the Fed to cut interest rates when it's safe to do so.

That, in turn, will help power the next bull market.

A more aggressive rate adjustment could facilitate a genuine economic reset... as opposed to a temporary reprieve from falling stocks.

It will also position us for future growth...

This wouldn't be the first time this economic cycle has played out. Back in 1947, the central bank began hiking interest rates to combat soaring inflation.

That period's inflation was primarily spurred by the economic surge following World War II. Supply couldn't keep pace with demand as returning soldiers went on a spending spree and manufacturing returned to normal.

To curb inflation, the Fed took measures to hurt the economy... just like today. By 1949, it had pushed us into a recession.

The Dow Jones Industrial Average fell as much as 20% during the downturn. Then, from the recession lows in June 1949 through the end of 1950, it rose 41%.

A recession might be the most suitable remedy for the economy of the 2020s... the same way it was in the 1940s. Consumers are once again flush with cash, this time because of a lack of spending during the pandemic. We've also seen high inflation, high interest rates, and other Fed measures to tighten credit.

For us, the central issue isn't just whether interest rates and bond yields surpass 5%. The bigger point is that for those rates to come down sustainably, the market needs a more serious reset.

Brace yourself for some turbulence in the short term. And try not to panic... It will be good for the market over the long haul.

Regards,

Joel Litman
October 30, 2023