Despite most investors more intuitive interpretation, we think the biggest risk to the market here is stronger than expected economic data and the illusion of a v-shaped recovery. Stronger data would force the Fed’s hand, reduce the potential for additional stimulus and nudge interest rates higher, along with the dollar. Risk assets would not take kindly to any of these shifts.
On the other hand, continued economic uncertainty would provide central bankers with the green light to keep the monetary pedal to the metal. While long term macroeconomic risks remain within the context of the New Normal, the near term potential for a continued “melt-up” in risk assets should not be underestimated as long as the proverbial “sweet spot” is prolonged.
If nothing else, our current Fed Chairman, and student of the Great Depression, understands that deflation is enemy number one. As such, the mistakes made during our prior bout with deflation are unlikely to be repeated. Fed Vice Chairman Donald Kohn recently stated that it is difficult for policy makers to spot asset price bubbles, but prices in U.S. financial markets “do not appear to be clearly out of line with the outlook for the economy and business prospects, as well as the level of risk-free interest rates . . . Tightening financial conditions at a time when an economic recovery has just begun, when labor markets are continuing to weaken, when inflation is below its optimal level for the longer run, and when significant strains persist in the financial system would incur a considerable short-run cost in order to achieve possible long-run benefits whose extent is, at best, quite uncertain.”
FedSpeak for Dummies:
We have not learned a single thing from the bursting of two major asset price bubbles in one decade. We are terrified of deflation, so generating another speculative rise in asset prices is the least worst alternative at this point. We support you Mr. Market and will not try to stop you (for now).