The twin beliefs propping up this market are crumbling

Janet Yellen © Getty
Janet Yellen left the US Federal Reserve on a high

The minutes from Janet Yellen’s final Federal Reserve meeting came out last night.

The upshot was that Janet went out on a high. The economy is looking strong and the Fed is feeling frisky. The chances of four – rather than three – rate rises this year went up.

So, of course, stocks promptly went down.

The twin pillars on which the market has been relying – central bank support and wobbly economic growth – are starting to shake.

What will it take for the “Goldilocks” (not too hot, not too cold) environment to continue?

The pillars propping up this market are looking shaky

It seems pretty clear that the market is trying to wrap its head around a potentially big change at the moment. There are basically two big variables that investors are wrestling with here – what central banks will do, and what will happen to inflation.

For quite a while now, the market has had its facts straight on two points: central banks will continue to underpin the market, and inflation will stay quiescent. Those two beliefs are now seriously being questioned for the first time since the financial crisis.

Let’s run through the backdrop quickly.

In the wake of the 2008 financial crisis, the market needed to be convinced of two things: central banks would not let the financial system – specifically the banking system – fail; and debt-driven deflation wouldn’t overwhelm and destroy all future economic growth.

Most central banks managed to win markets over on the first point quite rapidly once the money-printing started and interest rates were slashed to zero. And the victory of central banks was cemented when Mario Draghi finally drew a line under the eurozone crisis in mid-2012.

Markets weren’t so convinced about the second point though. The “secular stagnation” thesis caught hold, and the fight to ignite inflation was considered to be a losing battle amid gloomy views on innovation, demographics and technology-driven price wars.

That fear of deflation and “flight to safety” impulse almost certainly hit a peak in summer 2016, when the post-Brexit vote panic appears to have helped markets to realise just how overly jittery they’d been. At that point, they stopped holding their breath for the next disaster.

The election of Donald Trump also appears to have convinced investors (rightly, it appears) that governments would move to abandon any pretence at austerity and start spending big, to meet demands of jaded voters. That, of course, is inflationary.

So now, the two big pillars of investor belief that have driven the post-crisis rally are being shaken.

Maybe we don’t face decades of stagnation; maybe inflation won’t behave itself anymore. And, as a result, maybe central banks will get more aggressive and start to err on the side of hawkishness, rather than maintaining the idea of the “Greenspan put” at any costs.

What could help the market to make up its mind?  

So far, the market can’t make up its mind. Investors have moved away from seeing deflation in every shadow, but they still aren’t fully convinced that inflation is a big deal.

Yet they’re not so sure that the central bank has got their backs either. What worries them is that maybe the Fed keeps raising interest rates, and inflation doesn’t keep up. That’s what the market would view as a “policy error” – where the Fed tightens too fast and markets crash as a result.

For markets, for “Goldilocks” to continue for a while longer, you need inflation to keep ticking higher (and thus the economy to be strengthening), but you also need the Fed to lag behind inflation (thus maintaining loose, expansionary monetary policy).

What will give us clarity on any of this?

There are two things, really. Is the inflationary threat real? The only way to spot that is to watch the economic data, and wages and jobs in particular. Are they continuing to strengthen? Are we seeing genuine inflationary pressure coming through? Or are companies just spending their tax savings on share buybacks? And if they are, what does that mean politically?

The second issue is more about how the Fed reacts the next time the market genuinely tests it. Is the Greenspan put still in place, or are those days gone now?

The recent volatility flash crash, or whatever you want to call it, was – in the end – easy to shrug off as a blip. What happens if the market falls hard for more than a week? What happens if we get into bear market territory, rather than enjoying a brief dip into the “10% correction” area?

Will the central bank demonstrate as much bravado? Will it remain indifferent to the fate of the S&P 500? Will Jerome Powell really ditch the guiding central bank philosophy of the last 30 years? History suggests not.

But the trouble is, we won’t find out until the market decides to test the new Fed chief’s mettle by having a proper tantrum. My sense is that it’s currently looking for an excuse.