Explaining the Market’s Reaction to Jerome Powell’s Speech

Yesterday, Jay Powell and the FOMC gave us their decision on interest rates. In the accompanying statement and the subsequent press conference given by Fed Chair Jay Powell, they explained to some extent how they arrived at that decision and, more importantly, they also explained how they see the rest of the year panning out. As I'm sure you are aware, that news was greeted with glee by equity traders, with all three major stock indices jumping to record-high levels in yesterday's session. But is that response appropriate, and can it continue?

First, these are two separate questions because, as always, the market response to news is not just about the news itself. The stock market response can be appropriate to the news but not sustainable if the overall mood of traders and investors is bearish based on other factors. Or it could be that even an obvious overreaction will continue for months, or even years. Remember, the phrase "irrational exuberance" was coined to describe the dotcom boom two full years before stocks hit their highs.

So first, was this an appropriate response in stocks?

Well, there was certainly a shift in how Powell and the committee talked about their plans and how they intend to look at data going forward. That could be seen as bullish, but their stated intentions didn't really change at all. The market has been assuming three rate cuts this year for some time, and both the Fed's words and the so-called "dot plot", the chart of future rate assumptions by FOMC members, confirmed that that is the most likely path.

If that was already priced into the market, you might think that a positive reaction was not appropriate at all. If three cuts have been assumed for a while, why buy when the intention to cut rates three times is confirmed? That is because, even though stocks were close to all-time highs going onto the meeting, there was some doubt in the weeks leading up to it that the FOMC would maintain that view. Both CPI, the headline inflation measure, and the Fed's preferred measure, core PCE, showed increases in January and February, and the jobs market remained tight. Traders were therefore worried the FOMC would take a more hawkish stance at this meeting.

They didn't. In fact, if anything, a parsing of the language used by Powell suggests that the committee are even more committed to that path than they were before. As Seema Shah, Principal Asset Management's Chief Global Strategist put it when interviewed by CNBC, the wording yesterday suggests that "…he (Jay Powell) needs a good reason not to cut rates, rather than a reason to cut rates." The conscious decision to disregard two months of data that don't fit the narrative says a lot about where the FOMC is. They are prepared to hear what they want to hear and disregard the rest, to paraphrase the Simon and Garfunkel song.

That is a meaningful change whatever the number of forecast cuts to interest rates. It indicates that a further hike, which some analysts and economists had been muttering about, is completely off the table, and suggests that future data will be interpreted from an optimistic standpoint.

The response, then, looks appropriate, but is it sustainable?

Logically the answer to that question should be no, for the reasons mentioned above. Three cuts this year were priced into stocks going in, so as relieved as traders were that their fears weren't realized, nothing really changed yesterday. The market, though, as I have pointed out many times in the last twelve years of writing here, is not always logical. That shift in tone from Powell is important. It tells traders that rate cuts, which they believe are beneficial to stocks, are coming almost no matter what the data say.

There is a question as to whether, in the long term, reacting to positive data and ignoring negative reads is a good idea. For some people, resurgent inflation is far scarier than slowing the economy more than necessary by erring on the side of caution. For them, the Fed's optimism is not just inappropriate, it is irresponsible, downright dangerous even. By the end of the year, we will know whether or not that is correct, but in the meantime, with both the Fed and the market determined to look on the bright side, further gains look likely.