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The Fed will save the stock market and cut interest rates if a deep recession occurs next year, JPMorgan says

Fed Chair Jerome Powell
Fed Chairman Jerome Powell.Samuel Corum/Getty Images
  • The Federal Reserve could be forced to cut interest rates in 2023 if a deep recession occurs, according to JPMorgan.

  • The move would be an about-face by the Fed, considering it has aggressively raised rates in 2022.

  • Potential rate cuts from the Fed would help backstop the stock market in the event of a precipitous decline, JPMorgan's Marko Kolanovic said.

Just as fast as the Federal Reserve raised interest rates in 2022, they could do the exact opposite in 2023 and cut rates, according to JPMorgan.

That's if a deep economic recession materializes and corporate earnings plummet, JPMorgan's Marko Kolanovic said in a Wednesday note.

The Fed has been on an aggressive rate hike path so far this year, with another outsized 75-basis-point increase expected later today. That would push the federal funds rate to a range of 3.0% to 3.25% by the end of today, a far cry from its range at the start of the year of 0% to 0.25%.

By the end of 2022, current market expectations suggest the fed funds rate will be in a range of 4% to 4.25% as Fed Chair Jerome Powell seeks to extinguish high inflation readings.

Video: What people get wrong about the market's favorite recession signal

But interest rate hikes take time to flow through the economy, meaning there's an ongoing risk that the Fed overtightens as it focuses on lagging indicators while economic growth slows. None of this is lost on JPMorgan CEO Jamie Dimon, who is set to testify to Congress later today.

"Many Americans are feeling the pain, and consumer confidence continues to drop. While these storm clouds build on the horizon, even the best and brightest economists are split as to whether these could evolve into a major economic storm or something much less severe," Dimon said in prepared testimony.

A key factor to watch is if the unemployment rate begins to rise, as it has consistently stayed below the 4% mark since December. The rate recently nudged higher to 3.7% in August from 3.5% in July.

"The decline in earnings could become more significant if the unemployment rate starts moving up materially and a protracted or deep recession takes place," Kolanovic said. But such a scenario doesn't mean investors should ditch stocks, because the Fed could return to its years-long practice of easing financial conditions, according to the note.

"But even in this adverse scenario we believe that the Fed would be cutting rates by more than is currently priced in for 2023, thus backstopping equity markets and inducing higher P/E multiples," he added.

The market is currently pricing in a Fed pause in interest rate hikes for most of 2023, with two potential 25-basis-point rate cuts occurring towards the end of next year. Kolanovic ultimately believes those rate cuts could accelerate considerably if economic strength begins to deteriorate.

A potential markets-friendly Fed in 2023, combined with low investor positioning and a decline in long-term inflation expectations, suggests that downside in the stock market is limited at current levels, even if a slowdown materializes next year, Kolanovic concluded.

Read the original article on Business Insider