Goldman Identify The “Right” Recession Trade

Goldman Sachs note that “with the Fed appearing committed to bringing down inflation even as recession risks rise, yields have moderated somewhat from recent highs - the terminal rate in the US, which was priced at a little over 4% just a few weeks ago is now about 50bp lower, and closer to our economists’ forecasts. While we would ordinarily expect recession fears to translate to a significant steepening of forward yield curves, there is a complicating factor in the near term. Although market pricing of recessionary outcomes has increased (and that of high inflation outcomes decreased) since the Fed meeting, markets still perceive the risk that inflation remain stickier and more elevated than many analysts’ (and the Fed’s) forecasts as high - options markets suggest a roughly 1-in-3 probability of Fed funds greater than 4% by the June 2023.”

• “Barring the risk of an immediate recession, this upside risk should keep early 2023 Fed funds pricing relatively insulated on the downside; even under our economists’ policy path forecast, which is more front-loaded than market pricing, it will take until year-end to get to the Fed’s terminal rate range of 3.25-3.50%, and it will take perhaps a few months after before it starts to ease in the event of a recession. In our view, while early 2023 pricing has limited downside, fed funds pricing in 2024 is likely underpricing the risk of recession. Given this, we find March 2023/24 (EDH3/H4). Eurodollar curve flatteners compelling. However, rather than outright flatteners, we additionally like monetizing high implied volatility, and recommend selling EDH3 near at-the-money calls versus a long in EDH4 futures. We believe that this structure should perform under a range of recession start scenarios, with risks coming from either an immediate recession or a very prolonged hiking cycle.”