Markets and prices for a number of asset classes are currently behaving as they tend to around the time of a recession, says BNZ Interest Rate Strategist Nick Smyth.

Speaking in the latest episode of interest.co.nz's Of Interest Podcast, Smyth also says financial markets pricing in Federal Reserve rate cuts as soon as next year, despite the Fed's current aggressive hiking and US Consumer Price Index (CPI) inflation of more than 9%, suggests markets are worried about recession risk. 

"The market has got circa 90 basis points of rate hikes over the remaining three [Fed] meetings this year, so still got the Fed hiking quite aggressively over the remainder of this year. And then next year it's pricing just over 50 basis points of rate cuts with the first rate cut fully priced by June," Smyth says.

"So why is that?"

"The logical way to interpret it would be to say markets are worried about recession risk. And I guess you can kind of see evidence of that in various parts of the financial markets," says Smyth.

"So for instance the S&P 500 is down more than 20%. That's that definition of a bear market. Bear markets are often, but let's be clear not always, associated with a recession. The US yield curve is inverted, which historically has been quite a reliable leading indicator of recession."

"We've got industrial commodity prices like copper, and copper's kind of used in lots of different things [and] historically that has been quite a good barometer of the strength of global demand. And that had fallen more than 30% from its peak," Smyth says.

"So you've got a number of asset classes that are behaving in a way they normally would in the lead up to, or around recessions. And this is taking place in the context of central banks really aggressively lifting interest rates over a short period of time, and in quite a synchronized manner."

Excluding China, which has its challenges around zero-Covid, and Japan which still has relatively low inflation, Smyth notes even the European Central Bank is raising interest rates, having not done so for 10 years.

"So a synchronized global tightening cycle will certainly slow [economic] growth. And then we've got these other contributing factors that are giving markets concern about the rising risk of recession including the risk of lockdowns and restrictions in China, and the situation in Europe where you've got potential gas shortages and power rationing later this year."

"So I think asset markets are kind of telling you that there's at least a reasonable, if not a high chance, of recession next year. And historically during recessions the Fed cuts interest rates."

The Fed increased the Federal Funds Rate, its equivalent of the Official Cash Rate (OCR), by 75 basis points to a range of 2.25% to 2.50% on July 27.Smyth says markets see it peaking at between 3.25% to 3.50% in the current tightening cycle. And they see the OCR, currently at 2.5%, peaking at between 3.75% and 4%.

"And the New Zealand market now is reflecting that same profile as what the US is, so there are some rate cuts, albeit not as much as in the US, that are priced in to the short-end of our curve as well," says Smyth.

Meanwhile, Smyth says markets see US CPI inflation, currently running at a "staggeringly high" annual rate of 9.1%, dropping to about 7.5% by the end of the year, and then down to about 2.7% by the end of 2023.

"So that is a really big fall. And again that's consistent with the market thinking there'll be a recession or some kind of miracle with global supply chains," says Smyth.

In the podcast Smyth also talks in detail about this week's market reaction to the Fed's rate hike, what the yield curve is telling us at the moment, Reserve Bank and Fed quantitative tightening, or moves to decrease liquidity, or money supply in the economy, and expectations for Wednesday's Household Labour Force Survey from Statistics NZ, and what this will say about the labour/job market.