The Fed raised interest rates and the markets freaked out

The Fed raised interest rates and the markets freaked out

After Jerome Powell's press conference, all markets reacted aggressively and then quickly pulled back their moves as market sentiment changed overnight.

Two newsletters ago, I ended this column with "Zoom out. Think longer." And wow, weren't any of you listening. By "you" I mean "all of you," the stubborn Mr. Market who reacts violently to new news, old news and no news. Sometimes good news is even bad news.

The market does strange things, and that's why this week I wanted to take a closer look at the market's initial reaction during Fed Chairman Jerome Powell's FOMC press conference on May 4 and the subsequent pullback. This week's newsletter will be very chart-heavy, but the charts are necessary to tell the story I want to tell about today's markets and Mr. Market.

That (and perhaps more ...) below.

- George Kaloudis

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Eight times a year, the Federal Open Market Committee (FOMC) meets. The FOMC is part of the Federal Reserve System (the "central bank" or Fed) in the U.S. and is made up of 12 presidents of various Reserve Banks (the regional banks that make up the central bank). Powell is at the head of the FOMC. When the FOMC meets, it reviews the state of the economy, determines the appropriate course of monetary policy, and assesses the risks to the long-term goals of price stability and sustainable economic growth. After the meeting, the chairman holds a press conference to discuss the FOMC's view of the economy and announce changes in monetary policy - usually in the form of a change in interest rates.

On Wednesday, one such FOMC meeting took place, and Powell announced a 50 basis point (0.5% total) increase in the federal funds rate around 2:30 p.m. ET. I mention the timing because I want to focus primarily on that point this week. The image of Powell's face on the following charts marks the beginning of his press conference. The charts span a two-day period, from Wednesday to Thursday.

Here's the bitcoin:

The U.S. Dollar:

The Nasdaq 100:

The 10-year U.S. Treasury bond yield:

The S&P 500:

Gold:

Around 2:30 p.m. ET, all of these markets reacted. Bitcoin, Nasdaq 100, S&P 500 and gold all rose, while the yield on the 10-year U.S. Treasury bond and the U.S. dollar fell. Less than 24 hours later, all of these movements reversed as if nothing had happened. And then they reversed further (Bitcoin was wiped out on Thursday). It was almost as if Powell had issued a statement saying, "Psych!" and reversed everything he had said at the press conference.

Markets react

Before we go any further: What did Powell say and what should have happened? Powell's comments should not have had a positive impact on risky assets like stocks - period. Rising interest rates, inflation that surprised economists and a decline in first quarter GDP don't exactly scream "Wow, the economy is doing well - more risk please!"

Powell and the Fed also seem to have replaced the statement "inflation is temporary" with "we'll see a soft landing." This basically means that the Fed thinks, "Okay, inflation is high, but we'll get a handle on it without using the Volcker method." 'Full Volcker' refers to how former Fed Chairman Paul Volcker lowered inflation from 15% to 3% between 1980 and 1983 by raising interest rates to 20% - which would have been great if there hadn't also been a recession at the time.

OK, but the markets eventually turned around and did what was expected of them. Does that matter? I think it does. Here's why.

First, it reinforces the point I made three weeks ago, namely that market movements are driven by narratives. Admittedly, I stole this idea from Benjamin Graham, the spiritual father of value investing and Warren Buffett. Graham used Mr. Market as an allegory in his book, The Intelligent Investor, to describe the irrationality of the stock market and groupthink.

Markets are driven by narratives (especially in the short term) because of Mr. Market. On Wednesday, Mr. Market thought that a 50 basis point rate hike was not a bad thing, ignoring that inflation was high and GDP was shrinking. The very next day, Mr. Market said, "Oh, wait, inflation was pretty high. Now I'm afraid of inflation." That was the cue for the market reversal.

Second, (and I admit this may sound alarmist, but so what) this highlights the dangers of a highly interconnected, information-rich world where high-frequency trading and quantitative firms scour the Internet for clues on how to trade anything. And these firms can react to news faster than anyone else. And sometimes they can react "wrong." And now even Mr. Market can react quickly. One of the FOMC's stated goals is "price stability," and even though that goal relates to goods and services, market volatility is also destabilizing. It probably goes without saying (but I'll say it anyway): instability is generally not good.

Finally, and this is really my main point, the market is kind of ... uh ... absurd? I don't know. At the very least, it's too reactionary to ever be taken at face value. The market keeps howling wolf. Every time the market reacts to news, we should all take a collective breath and really think about what the news means.

With that in mind, I again challenge you: Zoom out. Think longer.