Potential indicators for a potential market downturn, as suggested by Deutsche Bank
Revised Market Sentiment: Mixed Feelings on Market as Recession Fears Loom Amid U.S. Tariffs
Financial experts forecast both increased U.S. inflation and decreased U.S. interest rates in the near future.
A glance at the U.S. stock and bond markets reveals a patchy outlook.
Navigating the U.S. market during this year has proven challenging, with President Trump's tariffs, the specter of creeping recession, and the specter of higher inflation making the market terrain "ready for a correction," according to Deutsche Bank's analysis on Tuesday.
Deutsche Bank identified three indicators that could signal another stock market correction looming.
Mixed Opinions on Interest Rate Cuts
Investors are betting that the Federal Reserve (Fed) will trim its policy rate by 100 basis points by December this year.
This perspective contrasts with projected inflation for the U.S. market. Deutsche Bank noticed that U.S. swaps - a type of financial market transaction - are indicating a projected inflation rate of 3.47 percent for next year, up from 3 percent in March.
Although the Fed has the potential to lower interest rates to boost the slowing economy, it primarily aims to curb inflation. With inflation on the rise, it is likely that interest rates will remain high for an extended period. Federal Reserve Chair Jerome Powell hinted at this in a recent speech, commenting that tariffs present a "difficult scenario."
"Amidst this context, markets may repeat an error made in recent years - overestimating the dovishness of the Fed, only to be surprised by reality," Deutsche Bank cautioned. "In 2022, 2023, and 2024, for example, markets consistently assumed a more dovish Fed than what eventually transpired."
A dovish monetary policy prioritizes growth over low inflation.
Market Behavior: Risk On, Risk Off
While calls for lower interest rates indicate investors bracing for a recession due to tariffs, stock markets are not behaving like a severe economic downturn is imminent, the bank noted.
"For instance, the decline in the S&P 500 from its peak to trough (-10 percent) does not match the magnitude of past recessions. Similarly, the U.S. high-yield bond spreads closed yesterday at 368 basis points - well below peak levels, even in non-recession scenarios," it added.
In other words, the losses in the stock and bond markets are currently not typical of a genuine recession. A 10 percent drop in the S&P 500 and relatively low risk premiums on high-yield bonds (U.S. HY-Credit Spreads) suggest that markets are not expecting a severe economic crisis at present.
The tale of the two-year U.S. Treasury bond yields, however, tells a different story: the bond yield is currently at its lowest level since October, hinting at a recession. This is because when investors fear an economic downturn, they tend to buy bonds aggressively, which increases their prices but usually reduces their yield. While bond markets are broadcasting warning signs, stock markets, as Deutsche Bank highlighted, are not.
"Given this discrepancy, there is a risk that if data continues to improve and point away from a recession, we could witness a similar situation to last summer, when yields rose quickly as investors adjusted to a more aggressive Fed and the absence of a recession," the institute observed.
As the United States grapples with trade tensions, increased inflation, and fiscal policy, only time will tell how these factors intertwine and impact the national economy and financial markets.
- Despite investors gambling on the Federal Reserve cutting its policy rate by 100 basis points by the end of this year, the projected U.S. inflation rate for next year, as indicated by U.S. swaps, is 3.47 percent, a rise from 3 percent in March.
- With inflation on the rise, it is anticipated that interest rates will remain elevated for an extended period, as the Fed's primary objective is to control inflation, not boost the economy.
- Contrary to the fears of a looming recession due to tariffs, stock markets are not behaving as if a severe economic downturn is imminent, even though the two-year U.S. Treasury bond yields are at their lowest level since October, signaling a potential recession.
- As the United States faces trade tensions, increased inflation, and fiscal policy, there's a risk that, if data suggests the absence of a recession, a similar scenario to last summer may occur, where yields rise quickly as investors adjust to a more aggressive Fed and absence of a recession.
