Oversold Period Ends, Stock Markets Jump Higher

The volatility index resumed its plunge from the Christmas Eve peak. The VIX even closed below its own up trending 50DMA.

In the last Above the 40 post, I lamented: “I absolutely hate feeling short-term bearish while the stock market is still in deeply oversold territory. Yet, the trading action, and now the economic and financial data, point to an extended stay in bear market territory.” I granted one key upside scenario: “Perhaps to the upside, government action from China and/or the U.S. will trigger a buying opportunity (most likely from monetary policy and NOT trade policies).” Friday’s rally was a double reminder of the dangers of getting too bearish during an oversold period and of forgetting how central banks are ultimately beholden to respond to the misery of financial markets. While China made yet more moves to ease monetary policy on Wednesday and more on Friday, it was Friday morning’s Fed-speak that truly turned the tide.

Fed Chair Jerome Powell hung out with his immediate predecessors Janet Yellen and Ben Bernanke to talk monetary policy, the economy, and the economics profession at the American Economic Association’s annual meeting. Below I summarize and editorialize some key remarks and answers, but I encourage readers to watch for themselves. In particular, Powell’s market-moving commentary started around the 5:30 mark of the video. That moment may become a key turning moment for financial markets even if the major indices make new lows before rallying again.

Powell noted that monetary policy is all about risk management in a time full of conflicting signals from a strong domestic economy, economic weakness in China, and financial markets projecting concerns about the future. The market experienced a tectonic shift when Powell next proclaimed:

As always, there is no preset path for policy. And particularly with the muted inflation readings, we will be patient as we watch how the economy evolves. We are always prepared to shift the stance of policy, and shift it significantly if necessary in order to promote our statutory goals…we will be prepared to adjust policy quickly and flexibly.

This statement is standard Fed-speak and would have been unremarkable except that up to this point financial markets had become utterly convinced that Powell was deadset on hiking interest rates and keeping monetary policy on a one-way course no matter what. To me, this statement was a simple reminder of the reality of monetary policy: when push comes to shove, the Fed will move when absolutely necessary. In this case, the stock market’s near unrelenting sell-off put pressure on the Fed. As I stated after the Fed’s December pronouncement on monetary policy: “A Fed Undeterred Is A Stock Market Not Yet Low Enough.” Sure enough, prices went lower, and the Fed went to work.

In case anyone was still unconvinced of the Fed’s underlying flexibility, Powell recounted an example of Fed flexibility from 2015-2016. He gave the exact same example last month. I am sure Powell repeated this example specifically to set-up an important point: the market has misinterpreted the Fed’s methods and intentions. He even accused the market of excessive worrying (emphasis mine): “The markets are pricing in downside risks and are obviously well ahead of the data.” Despite this supposed unnecessary panic, Powell reassured markets that “…we are listening sensitively to the message that markets are sending. We will be taking into account those downside risks as we go forward.” Powell effectively said that the Fed is not worried about the economy but if markets worry enough about the economy, the Fed will (reluctantly?) take the downside risks more seriously.

Powell next addressed the issue of quantitative tightening through the reduction in the Fed’s balance sheet. Here again, Powell emphasized flexibility that the Fed has already communicated in the past:

In 2014, we said that we would be prepared to adjust our normalization plans as appropriate….we wouldn’t hesitate to [make a] change… If we came to the view that the balance sheet normalization plan or any other aspect of normalization was part of the problem, we wouldn’t hesitate to make a change.

Over and over again, Powell told financial markets that the Fed is flexible, responsive, and attentive. Moreover, he has been a part of the Fed decision-making apparatus for many years. It was clearly the exact reminder financial markets needed.

There were other interesting items in this meeting not covered in mainstream financial media. Most importantly, Powell, backed up by the historical references provided by his peers, reaffirmed in no uncertain terms that the Fed is independent and not subject to political whims. Powell specifically insisted that the Fed has a strong culture. These references were a direct repudiation of President Trump’s attempts to verbally bully the Federal Reserve into following the monetary policy desired by the White House. Yellen even cautioned that while Trump has the right to comment on the Fed, such public rebukes cut against the practices established by recent Presidents and threaten to undermine the public’s confidence in the Fed.

The panel also addressed whether the Fed actively works against the interest of the common worker. Starting with Yellen, the Fed chairs refuted the premise – now maniacally promoted by the likes of CNBC’s Jim Cramer as his own special method of shouting the Fed into acting in a pro-market way – that the Fed acts specifically against the best interests of workers by moving to cool the economy just as job markets heat up and drive wages higher. Yellen referred to the Fed’s data dependency and the difficulty in correlating employment growth to inflationary pressures. Powell also emphasized that the Fed has been very willing to review its estimates of the natural rate of unemployment. Bernanke noted that well-anchored inflation expectations allow the Fed more leeway in experimenting with monetary policy in an era when the link between unemployment and inflation is apparently so weak.

The market’s dovish interpretation of Powell’s comments also had an impact on the U.S. dollar index. The dollar was rejected from overhead 50DMA resistance and closed down on the day.