After a sharp sell-off in early August, triggered by weaker-than-expected economic data, equity markets have staged a substantial rally.

The S&P 500 Index, as tracked by the SPDR S&P 500 ETF Trust (NYSE:SPY) recovered more than half of the decline witnessed earlier this month. The tech-heavy Nasdaq 100, monitored through the Invesco QQQ Trust (NASDAQ:QQQ), has fared even better, recovering nearly 70% of August losses.

This resurgence was bolstered by better-than-expected services survey data and a drop in jobless claims, which helped ease recession fears.

However, despite this positive momentum, recession risks remain, at least according to several economic models.

Bond Market Flashing Recession Warnings

The New York Federal Reserve's recession probability model, which relies on the Treasury spread between the 10-year bond rate and the three-month bill rate, currently suggests a 56% chance of a recession within the next 12 months.

This figure has garnered attention, as bond market signals are often viewed as more reliable indicators of economic downturns than stock market movements.

In response to cooler-than-expected jobs data, Goldman Sachs increased its 12-month recession odds by 10 percentage points to 25%. JPMorgan Chase has similarly raised its recession probability to 31%, up from 20% at the end of March, citing a sharp repricing in U.S. Treasuries.

The yield on the 10-year Treasury note has fallen to 3.85% on track for its fourth straight month of declines. Short-dated yields, which are more sensitive to interest rate expectations, have fallen by nearly 40 basis points month to date, after tumbling by 50 basis points last month.

The Fed's Wildcard To Escape A Recession

Investors are increasingly speculating that the Federal Reserve will step in with rate cuts if the economy shows signs of faltering.

The CME Group's FedWatch Tool currently prices in a 55% chance of a 50-basis-point rate cut next month, following cooler-than-expected producer inflation data.

However, as Goldman Sachs highlighted, the Fed has historically delivered larger rate cuts during clear economic crises or significant negative shocks, especially when jobless claims have surged — conditions that are not currently evident.

Investor Sentiment: A Cautious Shift

The Bank of America Global Fund Manager Survey highlights a shift in investor sentiment, with cash levels rising and optimism about capital expenditures falling to a nine-month low.

While a majority of investors — 76% — still believe in a "soft landing" scenario for the economy, there is growing concern that the Fed may need to cut rates more aggressively to stave off a recession.

The survey also reveals a rotation into bonds, with allocation to fixed-income assets rising to a net 8% overweight, the highest since December 2023. Conversely, allocation to equities has dropped to a net 11% overweight, the lowest since January 2024, signaling a more cautious approach among investors.

Read Now:

• Small Caps Set For A Comeback? Here's Why They Deserve Your Attention

Photo: Shutterstock