Goldilocks and the boiling frog.
Last Friday, Fed Reserve Chairman, Jerome Powell stated that if the US economy continues broadly on its current path, further gradual increases in the federal funds interest rate will occur.
So far, the market has been viewed as not too hot/(not inflationary) and not too cold/(not recessionary), that is, a ‘Goldilocks’ economy.
He also said that the slow and gradual approach to interest rates had reduced the risk of an unforeseen blow to the economy which could have pushed the economy into recession.
In other words, the Fed has been engaged in ‘normalising’ the cost of money through recalibrating interest rates and running off the balance sheet - a process started under the leadership of Janet Yellen at the end of 2015.
Like Yellen, Powell’s rate compass needle is tethered to unfolding economic data, and last Friday he cautioned that if the current positive outlook was to change, so too would monetary policy.
But he also noted that tariffs in general can push up prices. If that occurs, it may act like a shot in the arm for inflation as I speculated last week. Meanwhile, China has said it will fight back "at any cost".
In another cold shower for equities markets on Friday, Powell admitted he had not seen evidence of Dodd-Frank holding back Banks, and appeared to support keeping regulation in place (see Endnote).
This is a big deal because a winding back of Dodd-Frank's Volcker Rule would give equities and bond markets a fresh shot in the arm, like the Trump tax free kick did - but if Powell sticks to his apparent position of retaining Dodd-Frank, there will be one less reason for a rally.
Powell's comments point to increasing US interest rates in support of increasing growth, inflationary pressure, prudent banking system regulation, a normalising equities market, and potentially an increasing USD (good for Western Australia, all other things being equal).
On the other hand a few more weak labour market results could pour cold water on proceedings.
So, what we are currently witnessing is a shift from ‘this porridge is just right’, to the beginnings of what might become a ‘boiling frog’ scenario.
Under that scenario, I don't believe frogs go to sleep in tepid/warm water and remain asleep while they are being boiled to death. Whilst I am not about to run an experiment to prove it, I think it’s safe to assume that if the water gets too hot, the frog will jump.
I believe this has started and is what was driving last Friday’s 2.3% hit to the DOW Jones and a 13.5% increase in the fear index (i.e., the CBOE Volatility Index).
Endnote: The Volcker Rule is the part of the Dodd-Frank Wall Street Reform and Consumer Protection Act which prohibits short-term principal trading by banks in risky assets and ownership of hedge and private equity funds - its aim is to avoid another global financial crisis. One can imagine that if this rule was shredded, demand for risky assets would sky rocket.
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