The bond market signals the Fed will pull off a 'soft landing'

The bond market isn't buying recession fears.

Despite economists predicting a 30% chance of a recession in the next year, credit markets are surging, painting a much rosier picture of the future.

"Correlations between equities and credit are breaking down because higher-for-longer interest rates has been a negative for a large number of equities but supportive of credit in general because of yield-seeking investors," said Priya Misra, a portfolio manager at JPMorgan Asset Management.

According to market researcher LSEG Lipper, investors are pulling money out of traditionally safe stock investments and putting $675.5 million into riskier bonds, seeking better returns in a high-interest-rate environment.

The flight to riskier assets means Wall Street is convinced the Fed will pull off a "soft landing." The question remains: will it?

Can the Fed stick the soft landing?

Investors are seeing some of the highest yields in a decade as the Fed continues to hold off on a rate cut.

The issue here is this mad dash for debt could backfire if the Fed fails to engineer a soft landing and we find ourselves in a recession.

Recent economic data points to that possibility. June saw slowed hiring, increased unemployment, and a contraction in services activity – all potential indicators of economic weakness.

"Inflation is no longer the only risk we face," said Gregory Daco, Chief Economist at EY. "Maintaining excessively restrictive monetary policy when the labor market appears to be fully back in balance could lead to an undesired weakening of employment growth and the economy."

Vishwas Patkar, a strategist at Morgan Stanley, said this is the first time post-covid that we see signs of slowing across many areas.

"We don't want to see the economy slow too much further from here. If growth is too weak, you start to worry about fundamentals, defaults, and downgrades."

Morgan Stanley, however, remains optimistic about the credit market, not expecting a severe US downturn, though it acknowledges this as a risk. However, some investors are moving their money out of the US market following its strong performance this year. For instance, Amundi SA, a major asset management company, currently favors European investments due to better valuations.

As the situation unfolds, market watchers are closely monitoring credit market behavior and economic indicators for signs of how the economy might turn.

While there are some curious dynamics at play in the markets, some analysts are just glad the focus can now shift beyond interest rates.

"Major milestones for the Fed are all behind us," said Jeff Klingelhofer, co-head of investments at Thornburg Investment Management. "We can finally move on from incessant chatter about the Fed and return our focus to what really matters: the underlying economy."