Recession Fears for 2023 May Dampen Usual Santa Claus Rally

By the Curmudgeon


Despite the Fed’s seemingly never-ending pledge to maintain its aggressive rate hike policy (to fight the inflation that it caused), markets are pricing in that the world's most influential central bank will not raise rates above 5% and will be cutting them by year end 2023. 

In particular, the U.S. dollar (DXY) foreign exchange market, interest rate derivatives and the Fed Funds futures market do not believe Federal Reserve Board Chairman Jerome Powell’s rants and raves about more big rate hikes and for longer than expected.  Instead, Foreign Currency and Fed Funds Futures markets are forecasting that the Fed will be cutting rates in 2023 due to a sharp economic downturn. 

U.S. stock market participants are now worried about the Fed exacerbating the current recession by continuing to raise rates well into 2023.  Inflation fears have subsided for reasons we’ve documented in many recent Sperandeo/Curmudgeon blog posts.

Let’s have a closer look at these three markets:  U.S. dollar, Fed Funds futures, and U.S. equities.

U.S. Dollar May Have Peaked?

The DXY dollar is about 8% down since its multi-decade peak in September and has given up almost half its gains for 2022 as a whole. The dollar index moved below the 104 mark, down from 114.1 on September 28th and closing at its lowest level since June.  Foreign exchange traders evidently think that the Fed will stop raising rates in the first quarter of 2023 as the U.S. economy goes into a serious recession.

Here’s a six-month chart of the U.S. Dollar Index (DXY) which clearly shows the recent downtrend:

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Fed Funds in 2023?

Interest-rate derivatives suggest that investors expect the Fed to raise rates from their current level between 4.25% and 4.5% to around 4.9% by the middle of next year. After that, however, investors expect significant reduction in economic growth and easing inflation to quickly lead to looser monetary policy, with rates falling to 4.4% by the end of 2023 and roughly 3% by the end of 2024.

In contrast, the Fed’s latest interest-rate projections (dot plots) showed that the median official expected Fed Funds rate to end 2023 at 5.1% and fall only to 4.1% at the end of 2024.

The CME’s Fed Funds Watch Tool currently assigns a 70% probability of a 25 bps rate increase at the Fed’s Feb 1, 2023 meeting, which result in a range 4.5% to 4.75%.  54.8% of Fed Funds Futures participants see another 25 bps increase at the March FOMC meeting, with a terminal Fed Funds rate of 4.75% to 5%.

A plurality of traders expects the Fed to CUT rates 25 bps at both the November and December FOMC meetings, with 31% targeting a year end 2023 rate in the range of 4.25% to 4.5%.

Will U.S. Equities End December with a Loss?

The U.S. stock market evidently believes the Fed’s rate rise rhetoric as it’s on track to end December with a loss.  As of Tuesday’s close, the S&P 500 had fallen 6.4% this month.  The equity market expects the Fed to keep raising rates as the economy weakens which will have a very negative impact on corporate profits.

It’s important to note that Powell did not rule out a 50 bps rate hike in February during his news conference last Wednesday, December 14th after the Fed hiked rates by 50 bps (which was widely expected).  Equity markets had rallied into that news conference, expecting Powell to say that the next rate hike would be 25 bps and it would be wait and see after that.  When Powell refused to rule out a 50 bps rate hike in February and suggested rates would not be cut in 2023, equity markets dropped sharply. They continued to decline the next three days, with a more or less flat session today (Tuesday).

If stocks end December lower, it will be a somewhat unusual occurrence. The S&P 500 has risen in 73% of Decembers since 1928, according to Dow Jones Market Data. As of Tuesday’s close, the S&P 500 had fallen 6.4% this month. 

However, we are about to enter the “Santa Claus rally” time-window.  The Santa Claus rally refers to the stock market's history of rising over the last five trading days of the year and the first two market days of the new year.  Yale Hirsch first documented the pattern in 1972, writing in "Stock Trader's Almanac" that the S&P 500 had gained an average 1.5% during that seven-day period from 1950 through 1971.

The Santa Clause rally pattern has worked well since 1950, with the broad market index increasing an average of 1.3%. Additionally, the market has gained during those days in 34 of the previous 45 years, or more than 75% of the time.

What about year-end rallies within bear markets?  There was a Santa Claus rally in December 2008 to early January 2009 which was in the midst of the great recession/mortgage meltdown multi-year bear market. During the seven-day period of favorable seasonality, the S&P 500 gained 7.5%.  However, it then fell steeply for the next 2 ½ months before bottoming out on March 9, 2009. 

If there is a Santa Claus rally this year, expect it to be just another bear market rally.  We think stocks are likely to fall in early 2023 due to the U.S. economy weakening significantly with earnings forecasts dropping like a rock.

Cartoon of the Week:

Cartoon of the Day - 12.19.2022 let it slow let it slow cartoon
Cartoon by Bob Rich, Hedgeye


We wish all readers a joyous holiday season and a happy new year.  Victor and I wish you all the best in 2023.  Till next time.


The Curmudgeon

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies, and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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