In Wall Street's contrary logic, the stock market thrives on a little bad news every now and then. That’s in part because weakness in the economy makes it more likely the Federal Reserve will continue its aggressive loose-money policies, which may be the single-biggest factor fanning a bull market.
Like a parent threatening to take away a teenager’s credit card, Fed Chairman Ben Bernanke caused a momentary swoon recently when he suggested the Fed could start tightening its policy as early as this summer. When asked during a Congressional hearing what would trigger such tightening, Bernanke said, “It’s going to depend on the data.”
So the big question now is: What data? The Fed has two primary mandates: Keep inflation under control and maximize employment. Inflation isn’t a problem now and, if anything, the Fed might want to push it a bit higher, not lower. That leaves unemployment as the big problem; the unemployment rate is still an uncomfortably high 7.5%, with total employment 2.5 million jobs lower than its pre-recession peak.
A tightening formula?
The Fed, of course, doesn’t publish its formula for tightening policy, if there even is such a thing. It has said it plans to keep short-term interest rates low as long as unemployment is above 6.5 percent and there’s no worrisome inflation. But it could start to “taper” its other big stimulus effort — “quantitative easing”— well before unemployment gets that low. Since that’s the program that has impacted markets the most, investors are eager to know when it might change.
So investors are now trying to anticipate exactly what kinds of developments in the job market would prompt the Fed to curtail bond purchases that currently total $85 billion per month and are widely credited with pushing investors out of low-yielding assets and into riskier investments like stocks. In a research note, Bank of America Merrill Lynch recently suggested that job gains of 200,000 per month for four to six months might show the kind of labor-market improvement the Fed has been looking for, clearing the way for a reduced rate of bond purchases.
Job growth of that scale, however, could be hard to reach for a while. The economy has added an average of 196,000 jobs per month so far this year, but the pace has slowed significantly since a big and perhaps anomalous jump in February. Plus, many economists think the spending cuts known as the sequester, which went into effect March 1 and have faded from the news, are still likely to cause pullbacks in growth and hiring during the summer and fall. If the economy weakens in that way, the Fed is likely to stay the course for many months.
But the economy has been surprisingly buoyant lately, so investors are eager to make sure they don’t get caught flat-footed if the Fed begins to execute its “exit strategy” sooner than expected. One sign of concern, as the financial blog Zero Hedge pointed out: Web searches for the phrase “Fed exit” skyrocketed after Bernanke’s latest Congressional testimony.
Anything that raises the specter of a Fed exit tends to send stocks lower. So upbeat news about total payrolls, the unemployment rate, jobless claims, small-business hiring, or even secondary labor-market indicators could raise concerns about a Fed exit and trigger a stock selloff.
Even if that happens, some economists think it will be months before the Fed changes course. Research firm Briefing.com advised clients recently that there’s a stronger case for the Fed extending or enlarging quantitative easing than for pulling back. “The simple fact is that unemployment is too high,” the firm’s economists wrote. Jittery traders, however, may be more comfortable jumping the gun than reacting late once the Fed signals an exit. By the time the Fed really does tighten its policy, the market will have anticipated it many times.
Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.