Dear Stock Market: You Can’t Have It Both Ways

Authored by Charles Hugh Smith via OfTwoMinds blog,

Eventually reality will intrude in this pleasant madness.

OK, let me see if I have this right: the stock market is soaring because the economy is softening, so the Federal Reserve panicked and went from raising rates to considering cutting rates.

It seems markets are now assuming a rate cut is already locked in, given the Fed’s commitment to cease trimming its balance sheet by September.

This dovish reversal means liquidity is flooding back into stocks and bonds, and so stocks are rising as once again “the Fed has our backs.”

OK, I get it. But the market is also rising because punters and pundits are assuming the soft spot in economic expansion has ended, and growth is already resuming globally. The positive data out of China is taken as proof-positive of this resumption of expansion.

Now wait a minute–the market is rising because growth is softening and also because growth has resumed? Sorry Stock Market, you can’t have it both ways. Either the global economy is stagnating, forcing central banks to flood the financial system with more liquidity, or growth is resuming, in which case raising interest rates are back on the table, especially if wage inflation kicks in.

If growth resumes, not only will the Fed have a green light to raise rates, it will also face pressure to resume trimming its bloated balance sheet.

Many observers have noted that the sharp decline in Treasury bond yields is signaling fear that the global economy is recessionary, and central bank goosing isn’t going to reverse the slowdown. Meanwhile, stocks are schizophrenic: going up because growth is slowing and Fed rate cuts are now in the bag and going up because growth has resumed.

Central bank and financial authorities are keen to continue the schizophrenia because markets have no excuse to drop: if growth has stagnated, markets will continue soaring, and if growth has resumed, markets can continue in overdrive.

Eventually reality will intrude in this pleasant madness: either the global economy slips into recession and corporate profits tank, kicking out the props of high stock valuations, or global growth resumes, opening the door to stock-market-killing rate increases and balance sheet reductions.

Here’s one way to visualize this moment in history: global financial markets are in the eye of a very large hurricane: