(Bloomberg Opinion) -- At this time last year, everyone was waiting for Santa Claus and his rally — and he never showed up. Instead, there was a brutal stock market sell-off. A year later, we have a surprise visitor: Goldilocks.
The cliche has it that a Goldilocks economy is neither too hot (to push up rates and inflation) nor too cold (to push down share prices and employment). It is an irritating way to describe ideal conditions for markets and the economy. For the decade since the financial crisis, it has seemed absurd to suggest the U.S. economy is in any such fairy tale. The Federal Reserve saw a risk of over-heating and spent 2018 tightening monetary policy, only to be forced by the horrified market reaction into executing a U-turn in 2019.
As the year comes to an end, Goldilocks is back. The unemployment rate, at 3.5%, is as low as it has been in half a century, while core inflation, at 2.4%, remains comfortably within the target range of between 1% and 3% — which it has occupied for a quarter of a century.
If we use President Jimmy Carter’s old concept of the Misery Index, adding the core inflation and unemployment rates, we find misery is close to its lows of the last 50 years:
There’s also something distinctly Goldilocksy about market views of the Fed. After two years of persistent bets that the U.S. central bank would be forced to cut far further than it wanted, fed funds futures are now implicitly pricing only one more quarter-point reduction from the current level, and see any additional cuts as unlikely until 2020 is half over. Fed Chair Jerome Powell has already said that he thinks monetary policy is in a good place and that he sees little reason to move it; approaching the last rate-setting meeting of the year in a few day’s time, it appears the market at last cautiously agrees with him.
Many believe that the Powell Fed has listened to good advice, and thus thwarted an incipient recession. That helps to explain why the S&P 500 Index is now up more than 25% for the year, and within a whisker of its all-time high set in November, amid low volatility. But the very strength of that sense of relief now opens the risk that the economy moves in short order toward running too hot.
It is very unusual for the Fed to cut rates three times in quick succession when the economic backdrop otherwise looks this strong. The only comparison that comes close is 1998, when the central bank under Alan Greenspan cut the fed funds rate by 75 basis points in the wake of the market disruption caused by the meltdown of the Long-Term Capital Management hedge fund. That fueled one of the most dramatic stock market rallies in history, which ended with the bursting of the dot-com bubble in 2000, and a recession.
In retrospect, those rate cuts appear to have been a mistake. Will history come to view this year’s U-turn toward cheaper money in the same way?
The LTCM debacle, which followed Russia’s debt default and the Asian crisis, was a special and very different case. Corporate credit markets ground to an almost total halt, in a dry run for the credit crisis that would follow a decade later. The Fed felt obliged (rightly or wrongly) to act to stop a financial accident, and in the process provided the money for a stock market mania.
Markets have at no point this year looked anything as extreme as they did during the LTCM crisis. But there is a critical similarity: As in 1998, we saw a sudden summer resurgence of recession fears. Google searches for the word “recession” in the U.S. spiked in August to levels unseen since the country was last in recession:
There were reasons for the fear. The trade war intensified during the summer; the European Union’s manufacturing sector fell into recession; long-term bond yields went negative in much of the world; and the U.S. Treasury yield curve inverted in what is usually a sure-fire indicator of an imminent slump. This was enough to “create a recession in the minds of most,” as Leuthold Group’s chief investment strategist Jim Paulsen put it. Hence the unambiguously strong employment data for November — published at the end of a week which had also revealed plenty of data suggesting a recovery in global manufacturing — feels almost like exiting a recession to many investors. The reality is, as in 1998, the U.S. economy has remained strong throughout.
The 1998 analogy cuts both ways. The economic recovery carried on for a while, and late 1998 proved to be a great time to buy stocks. The problem was that this soon turned into an economic over-heating, prompting the Fed to begin a series of rate hikes in May 1999. And of course anyone who bought stocks needed to be prepared to sell them quickly.
Even though economic misery is near all-time lows, then, we will probably soon start questioning whether the Fed cut rates too much. And while the conditions seem good for a Goldilocks boom in share prices, the Fed has cut at a point when stocks already looked very expensive (in another echo of 1998). Just as in 2000 (also a presidential election year), we can expect questions about asset-price bubbles in 2020.
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John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of “The Fearful Rise of Markets” and other books.
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