Headlines are ominous , recession prediction models are flashing yellow , yield curves have inverted, economic data has decelerated and yet the US stock market remains within 5% of all-time highs. What gives?
In 1975, British economist Charles Goodhart wrote a paper titled “Problems of Monetary Management: The UK Experience”. In this paper Goodhart wrote:
“Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes”
Said differently, when a measure becomes a target it ceases to be a good measure. This later became known as Goodhart’s law, and I believe it can help us explain the state of today’s markets.
In a prior blog, I spent time discussing financial conditions (FC for short). I explored both what they are and why they matter. The main point I tried to make at the time was that the Fed uses directly observable FC as a proxy for the current stance of monetary policy. As such we need to pay attention to changes in FC for clues regarding upcoming changes in monetary policy.
For the purposes of this blog, let’s call FC the “measure” and the current stance of monetary policy the “target”. If FC remain at levels consistent with the Fed’s stated policy stance, then the Fed will conclude that inflation and unemployment should move toward their goal and no policy action should be anticipated. If FC tightens to levels that would be seen threatening the unemployment rate, the market can expect the Fed to step in and ease policy. The Fed has made FC their unofficial measure for the stance of monetary policy.
I hope you see where I’m going with this.
Markets, being forward looking and profit maximizing entities, have begun to look through the part of the cycle where stocks selloff and credit spreads widen prompting the Fed to ease policy. As a result, bonds have rallied aggressively and stocks have maintained lofty valuations in the face of deteriorating fundamentals. No one wants to sell their stock right before the Fed steps in and aggressively eases policy. It’s as if both markets are preparing for QE in the face of a possible recession. Even the president of the Boston Fed, Eric Rosengren, said as much just this week. “It is very likely we’ll end up doing QE in the next recession.”
In the words of Goodhart’s law, the statistical link between FC and the stance of monetary policy has collapsed. This is a direct result of the Fed using FC as a policy target. If the Fed only looks at the current state of FC they will conclude that all is well and no policy action is needed. This would be a massive policy error in my assessment. Due to the perversion of incentives introduced by implicit FC targeting, the stock market is holding current valuations in anticipation of Fed easing. If that easing does not materialize, valuations will have to adjust materially lower. Perhaps the bond market and the stock market are discounting the same outcome after all?
 – Bloomberg TV interview 8/19/19