Rates rally while recession odds diminish, go figure

Despite the cross-asset rally in recent weeks, market-implied recession probability models reveal a growing divergence between front-end rates and other assets. While the market's pricing of recession risk has trended lower, the approximately 125 basis points of cuts priced in by the market over the next 12 months suggest a higher perceived probability of recession. This divergence is notable, and the extreme easing currently priced into front-end rates appears at odds with diminishing recession expectations.

With the monetary policy factor rather than a slowing growth factor driving the bulk of the recent rates rally, traders could be in for a bit of a rude awakening on stronger data or a coordinated hawkish Fed pushback on the extent of rate cuts priced into the curve. 

The coming weeks will bring clarity on the macro and policy path. Key events include US unemployment and NFPs, US CPI, the BOE meeting, and the FOMC meeting, where the committee will revise the Summary of Economic Projections, including the Fed Fund rate dot plot for 2024 to 2026. Options markets are pricing in volatility to peak over the next two weeks, with expectations for a partial reset afterward.