Trading Strategies for 2023: Analytical Skills, Strategic Thinking, and Risk Management

The year 2023 is shaping up to be a challenging environment for traders, with central banks around the world pausing by the second quarter. The US Federal Reserve has already hiked rates by 400bps in 2022, and there is more to come in 2023. The December 'dot plot' showed that the Fed sees the terminal rate for this cycle at >5%, which is higher than what they had previously projected in September.

What does the market think? The current pricing suggests that the Fed will hike to 4.75% in March (25bps) and then again to 5.00% in May, before pausing at June's meeting. However, it became evident at February's FOMC meeting that the tightening process is drawing to a close. The pace of rate hikes slowed to 25bps in February, and Powell recognized that the 'disinflation' process is now underway for the first time this tightening cycle. He also stated that it was 'gratifying' to see both disinflation and strength in the job market at the same time.

Although it's early, this disinflationary trend and job market strength are becoming indicative of a 'soft landing' in 2023. However, so long as inflation continues to fall to the Fed's target and the job market is strong, rates will remain higher for longer. This is where a 'soft landing' could very quickly turn into a hard one for the US economy. The Fed can afford to keep rates in restrictive territory, so long as inflation falls and employment is strong. Higher rates for longer will destroy demand and depress economic activity.

For a soft landing to occur, data needs to continue trending as it has been for the past 4-6 months, with inflation lower and the job market stable. But this is highly unlikely, given the lagged impact of monetary policy on the economy. It typically takes ~12 months for the full effect of tightening to filter through into economic data. While we're seeing strong employment data now, the demand destruction caused by unprecedented hiking in 2022 is yet to be reflected. However, expect that to begin in 2023.

While a Fed pause is close (~June), it will not be enough to spur the next leg higher in risk assets. Historically it's taken 6-12 months following a 'pause' in tightening for true deterioration in the job market to begin and for demand destruction to become real. For this reason, markets have not bottomed immediately following a Fed pause. Instead, a bottom and new bull cycle come when economic activity stabilizes post-pause. In 2023, it's simply a question of how much deterioration the Fed has caused and if they can identify that early.

Although the Fed should be more well-equipped to deal with deterioration in the employment market in 2023, the challenge will be keeping inflation at bay at the same time. The Fed did engineer a soft landing in the mid-'90s, but this time around is arguably a little different. Productivity has dipped, levels of debt are substantially higher, and inflation is substantially elevated.

If inflation remains elevated and the job market deteriorates, it's game over for risk assets for a while on a hard landing. That scenario would lead to a prolonged period of negative growth (a recession), and cash will become king for a while.

Picture a scenario where the Fed pauses rate hikes by June 2023, inflation remains elevated but drifts toward the target, and the employment market deteriorates soon after. The Fed will need to respond to a deteriorating employment market (and economy) by cutting rates sooner than thought, and that's exactly what risk assets need. All major central banks end up doing the same thing eventually. In 2023, traders will need to stay vigilant and closely monitor economic data releases and policy announcements by central banks. The market will also be closely watching for any signs of a hard landing or a recession, which would be a major risk for investors.

In such a challenging environment, traders will need to adopt a flexible and adaptive approach to their investment strategies. They will need to be ready to adjust their positions quickly in response to changing market conditions, as well as to seize opportunities as they arise. This will require a deep understanding of market fundamentals and an ability to identify and interpret key indicators.

Ultimately, successful trading in 2023 will require a combination of analytical skills, strategic thinking, and sound risk management practices. Traders who can navigate the challenges of the year ahead while staying focused on their long-term goals will be well positioned to outperform the market and achieve their investment objectives.