There are several fictional characters that populate the market’s narrative. Mr. Market is a common construct, and in the last week alone I referred to both “TINA FOMO” and Mary Poppins to explain the market’s motivation to buy stocks no matter what and trader’s willingness to accept economic medicine as long as it is presented properly. Yet Goldilocks remains the most popular fictional character among traders and investors alike. An economy that is hot enough to perpetuate earnings growth yet cool enough to keep monetary authorities at bay is the market’s sweet spot. In his kickoff address to the Kansas City Fed’s annual Jackson Hole conference, Federal Reserve Chairman Powell played the role of Goldilocks and markets loved his portrayal.
It takes some real skill to offer economic news that pleases both stock and bond markets simultaneously, but we saw both markets rally on Friday and continue their advances into Monday morning. A Goldilocks scenario is the only one that allows bonds to dismiss fears of higher inflation while at the same time leading to an environment that favors smaller, more economically sensitive stocks. Although the Russell 2000 Index (RTY) is about ¼% lower this morning, it was a significant outperformer on Friday when it closed nearly 3% higher. Meanwhile, 10-year Treasury yields are over 2bp lower, bringing the two-day dip to nearly 7bp.
Some of the markets’ enthusiasm stemmed from Mr. Powell’s announcement that interest rate hikes were not on the horizon. Should that have mattered? Stocks typically discount events 6-12 months into the future, and the Fed Funds futures market had not been anticipating a rate hike before early 2023. In theory, Mr. Powell’s statement was already priced in. In reality, it was welcome news to bullish traders.
Some of the markets’ enthusiasm stemmed from Mr. Powell’s comments about inflation. As we noted on Friday, much was made about comments that reflected his belief that inflationary pressures continued to be largely transitory. Yet he also stated that the Fed’s target of persistent 2% inflation appeared to be met. That is potentially contradictory unless we take the view that inflationary pressures that led to readings above 2% were transitory. Traders seemed to either take that view or focus on the more convenient part of the message.
Some of the markets’ enthusiasm stemmed from contrasts with prior comments from Mr. Powell’s warm-up acts fellow Fed Governors. Financial media was filled with reports that various Fed Governors were urging that the FOMC begin tapering its roughly $120 billion in monthly bond purchases as soon as October. Mr. Powell’s comments softened that language considerably. He appeared to be in no rush to begin tapering while also seemingly less eager to slow the rate of purchases than his colleagues. Although he still seemed to imply that a tapering decision was now a matter of when it will begin, not whether it will occur, his comments were vague enough to give traders comfort that monetary stimulus could last longer than many anticipated.
It is important to remember what tapering is and isn’t. It is more akin to a driver taking his foot off the accelerator rather than tapping the brakes. When it tapers bond purchases, the Federal Reserve will still be adding to the monetary system and its balance sheet by purchasing bonds in the open market, just at a slower pace. Eventually if they halt it altogether, the balance sheet could begin to shrink as some of the bonds on the Fed’s balance sheet naturally mature. But even the most hawkish members advocate for tapering to end about a year from now. Any monetary tightening, no matter how slight, will not be evident for months – especially if rate hikes (which are akin to tapping the brakes) are not on the horizon.
Bear in mind that “too hot” and “too cold” are relative terms. We don’t know how the temperature of the “too hot” porridge that Goldilocks disdained. Traders and investors gave an assessment of Chairman Powell’s heat tolerance after his Jackson Hole speech and found it very much to their liking.
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