Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

What happened to the world coming to an end?

Rate hikes getting priced back into markets: Pro

Just a couple of weeks ago on Wall Street, it looked like the world was ending, the market was crashing and all was lost. Now, it looks like the world is safe again.

What happened?

Not really a whole lot if you look at the data. Jobs are still being created, but manufacturing and corporate earnings both remain in contraction. Though auto sales have been powerful, retail sales remain modest and wages actually fell in February. Housing data have gotten arguably weaker and first-quarter GDP growth may not exceed 2 percent after just 1 percent growth in the fourth quarter.

The primary thing that seems to have changed is that while no one thinks growth is ready to accelerate sharply, the employment gains and rebound in oil are suggesting that a recession is unlikely. In turn, there's a growing feeling that the worst of the global growth scare that emerged in mid-2015 has passed.

"There's a feedback loop of noise and bias to the downside within the professional investing/trading/media world. Every single time we have a downturn, people go to the narrative of the the worst-case scenario," said Zachary Karabell, head of global strategy at Envestnet. "It's a familiar pattern."

Clearly, that loop has been broken, at least for the moment. Just as quickly as Wall Street economists had been warning that recession risks were rising, they began dousing those same expectations. While economic indicator readings are mostly tepid, at least on a directional basis more are pointing higher than at any period in at least a year, according to Bespoke Investment Group.

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Goldman Sachs, which has been cautious in its view of the economy and even more so the stock market, said in a note over the weekend that recession risks are "remote." Several Wall Street economists celebrated Friday's nonfarm payrolls report, showing February job gains of 242,000, as a "Goldilocks" number for being not too hot to generate Fed tightening and not too cold as to raise worries about growth. And Bank of America Merrill Lynch economist Ethan Harris flatly told clients to "get over it" in regard to recession fears.

"Despite all talk of an impending recession, the U.S. and global economy refuse to roll over," Harris said in a note. Of current conditions, he remarked, "The better tone to the data has ... pulled global markets out of their funk. Fading fears of a complete collapse in oil prices has also helped, along with reduced fears of a big China devaluation or hard landing. As these tail risks fade into the rearview mirror we would expect the risk-off trade to continue to fade."

Harris' admonitions were particularly striking after BofAML's strategists had noted in previous weeks that financial markets were pricing in up to a 70 percent chance of recession.

Indeed, there have been three significant ramifications of fading fears: Surging prices in a bear market for oil, rising values in a stock market that had been in correction mode and renewed expectations for a Fed rate hike.

Amid the hand-wringing over a looming recession came speculation that not only would the U.S. central bank not hike rates at its next meeting on March 15-16, but it might not raise rates at all until late 2017 or early 2018 and could, in a pinch, institute negative rates on bank reserves parked at the Fed. Those dovish expectations have shifted, though the market still expects a gentle glide path for rates.

Fed funds futures contracts now have a rate hike fully priced in for December 2016. Some on Wall Street expect the path to be even more aggressive, with Goldman Sachs projecting three increases in 2016 and BofAML looking for two this year and three in 2017.

Tom Porcelli, chief U.S. economist at RBC Capital Markets, said he thinks the Fed should go ahead and hike next week.

"We get that when it comes to monetary policy, concerns about market stability and global headwinds have trumped the resilience in the U.S. economy," Porcelli said in a note. "But even here there has been some considerable improvement over recent weeks." The has jumped about 6 percent over the past month.

Even if it chooses not to move, Porcelli said the Fed and Chair Janet Yellen should use the March meeting as a chance to "reprice market expectations about the Fed rate hikes this year."

Of course, this newfound enthusiasm comes with a risk the U.S. central bank probably won't be willing to take: That the current rebound is merely a bounce off the bottom and more volatility is ahead.

"I wouldn't for one minute say we're at the end of flurries of panic and volatility," Karabell said. "I just don't know where the next one is going to come from and why."