In a significant market shift, investors are increasingly betting that the Federal Reserve's rate hiking cycle may not end in a recession, as the stock market rallies and economic surprises continue. On Tuesday, inflation data revealed a cooling of pricing pressure at a faster rate than expected, resulting in a notable drop in yields tied to the 10-year Treasury. As a result, major stock indices, including the S&P 500 and Nasdaq Composite, experienced their best performance since April, while the small cap Russell 2000 witnessed its strongest day in a year.

For months, Goldman Sachs has maintained a position that the US economy could potentially avoid a recession, and David Kostin, the bank's chief US equity strategist, believes that the recent market movements reflect investors beginning to incorporate this perspective. Kostin remarked during a media roundtable that portfolio managers, who have expressed concerns and risks, respond sharply to information that supports the notion of economic growth.

The recent series of "economic surprises" have played a significant role in shaping market sentiment. The most recent retail sales report indicated a decline in consumer spending, though not to the extent of plummeting off a cliff. Additionally, October jobs data highlighted slowing wages, a crucial factor for preventing a resurgence of inflation, while job growth showed signs of moderation.

These observations have led the market to consider the possibility of a "soft landing" scenario, where inflation returns to the central bank's targeted 2% level without a severe economic decline, high unemployment rates, or a subsequent recession.

The concept of a soft landing has faced disappointment before. In February, Federal Reserve Chair Jerome Powell expressed optimism about achieving the Fed's primary objective of reducing inflation while avoiding a significant economic downturn or increased unemployment. However, a robust jobs report released shortly after left investors concerned about the rapid growth of the labor market, impacting the hope for a soft landing.

Gregory Daco, chief economist at EY, acknowledged that the elements required for a soft landing are apparent in recent data. However, Daco cautioned against overemphasis on monthly reports, citing the influence of the Fed's narrative. He stressed the need for sustained progress in multiple indicators to confirm a soft landing.

While the prospect of a soft landing may be stronger now than in February, experts still acknowledge potential risks. The "higher for longer" interest rate campaign pursued by the Fed could tighten financial conditions and hinder business activity. Daco emphasized that the key factor would be its impact on the labor market. If reduced revenue leads to layoffs and subsequent rise in unemployment, it could trigger a vicious cycle potentially leading to a recession.

Goldman Sachs' chief economist, Jan Hatzius, remains optimistic, citing the continuation of disinflationary trends and the expectation that consumer spending will hold up despite decreased savings. Hatzius suggested that the last phase of disinflation should not be particularly challenging.

Despite the growing optimism, economists like Daco emphasize that celebrating a soft landing is premature until inflation returns close to the 2% target, and the economy continues to move forward. As 2024 approaches, the question of whether the current trends can be sustained remains open.

Overall, the market's recent response and the ongoing "economic surprises" indicate that investors are beginning to incorporate the possibility of a historic rate hiking cycle ending without a recession, although experts caution that sustained progress is necessary before declaring the achievement of a soft landing.