The US could be heading for a recession — that's great news for stocks

• Stocks surged through July despite growing recession fears and dismal economic data.
• The rally was fueled by investors betting the US economy would slump and the Fed would lower rates.
• Low rates lift stock prices, which means bad economic news is actually good for investors.

The economy is shrinking, and Americans increasingly fear a recession is either on the horizon or already here. Yet the stock market is positively thriving.

The S&P 500 leaped 9.1% in July alone, notching its best monthly gain since the post-lockdown rebound of November 2020. The benchmark now sits at the highest level since early June. Other indexes similarly jumped, signaling the market pessimism that dragged prices lower through much of 2022 could be turning around.

The rally flies in the face of the economic backdrop. Data out last week showed the economy shrinking for a second consecutive quarter, amplifying concerns that the US was heading toward a downturn. Inflation remains at four-decade highs. Americans' financial cushions are quickly fading, and their confidence in the economy sits near record lows.

But all that bad news could have a silver lining for investors: A downturn might force the Federal Reserve to walk back its fight against inflation and lower interest rates in the next year, which tends to be a big boon for stocks.

Interest rates play a major role in shaping stock valuations. Lower rates boost valuations, as they make it cheaper for companies to borrow. Conversely, higher rates can weigh on the market by intensifying firms' debt burdens and slowing the pace of borrowing.

The Fed has been raising rates throughout 2022 in hopes of cooling inflation. That pushed stocks lower, but the latest batch of bleak economic data has investors shifting their bets. Traders now expect growth to slow so much that the Fed will have to pause its rate-hike plans entirely and slash its benchmark rate to buoy the economy. That outlook powered the strong upswing through July.

To be sure, there's no guarantee investors will get the rate cuts they're betting on. Fed Chair Jerome Powell said Wednesday that "it will likely be appropriate" for the central bank to slow its hiking cycle after raising rates at the fastest pace since the 1980s.

Yet there's plenty of room to slow the pace of increases before halting the cycle. The Fed raised rates by 0.75 percentage points at both its June and its July meetings, tripling the size of its typical hikes.

Fed officials have also signaled they aim to keep raising the benchmark through 2023. Economic projections published after the central bank's June policy meeting showed participants expecting the federal funds rate to reach 3.4% by the end of 2022. That's up from the current range of 2.25 to 2.5%, which indicates the equivalent of another four normal quarter-percentage-point hikes at the Fed's three remaining meetings this year.

Members then expect the benchmark to hit 3.8% by the end of 2023 before sliding back to 3.4% in 2024. That implies some easing through the year but not enough to pull rates low enough to provide a big economic boost.

During a Wednesday press conference, Powell poured some cold water on investors' confidence that a near-term rate cut was in the cards given how hard it is right now to guess where the economy and inflation will be going in the coming months. The Fed's June estimates are "the best estimate" of what the Fed anticipates, but there's still "so much uncertainty" around the path of the economy, he said.

"You've got to take any estimates of what rates will be next year with a grain of salt," Powell said. "There's significantly more uncertainty now about the path ahead than I think there ordinarily is, and ordinarily it's quite high."

Put simply, there's no guarantee that investors will get the lower rates they're hoping for. But as recession fears loom large and signs point to a slowing economy, the chances of a Fed pivot are ticking higher.