Today's steep selloff was launched by the latest jawboning by Lockhart and Williams who, now that the S&P 500 is back comfortably above 2000, once again hinted that a June rate hike is back on the table. Incidentally, the dynamic of the Fed responding to the market, and the market responding to the Fed, has been the only one worth paying attention to in recent months.
Confused? Don't be. Here is an explanation from none other than Bank of America.
Not so merry-go-round: By some accounts the Fed is stuck in an adverse feedback loop. They want to raise interest rates so they can "reload" their policy ammunition, but the markets won't let them. The chart of the day illustrates this nightmarish merry-go-round: the Fed threatens to hike, markets tank, the Fed delays the hike, the market recovers and the cycle repeats. The end result is repeated delays and very little actual policy tightening.
While we think there are elements of truth in this argument, we think it exaggerates the constraints on the Fed in two ways. First, if we are to believe the story, the timing of this feedback loop shifts from one episode to the next. In particular, in the first three episodes the market responded to the threat of tighter policy, but not to the actual implementation of policy; while in the December case the market was fine with the threat of hiking but only reacted weeks after the fact. So which is it: are markets forward looking or not? Second, the Fed merry-go-round story puts the entire onus on the Fed when a lot else is going on.
Of course, there is a very simple explanation for the above: as George Soros would certainly dub it if he were in a mood to write books, the term would be a "reflexivity trap."
As pertains to Bank of America's question, regarding the second, the Fed chose to take on the "onus" in 2009 when it decided to centrally-plan the world's most artificial market rally in history, so they will get no commiseration from us.
As for the first, "are markets forward looking or not", the answer is simple: the markets can only look as far forward as the next Fed statement... and since the next Fed statement is in turned driven by what the market will do at any given moment, it explains why the only chart traders need is Bank of America's "nightmarish merry-go-round."