Markets Are Stuck In Overreaction Mode

I. Summary:

• On Monday, the Institute of Supply Management’s Manufacturing Index came in a little weaker than forecasted. This prompted an extraordinary rush to buy bonds as bets mounted that the Fed would raise interest rates less aggressively. This rush continued into Tuesday, when bond yields continued falling and stocks starting off well, boosted by falling job openings, signaled a weakening labor market.
• The problem is that a single data point is not sufficient enough to describe what is happening in the markets. Eventually, the whole 'bad-news-is-good-news' pattern will shift back to bad news being bad news once it looks like recession is on the way.
• The Fed will raise rates much more to crush inflation, squashing the economy in the process. The outlook for interest rates dominates stock-price moves.
• Another issue is that economic data tends to swing from month to month, while the market treats them as the gospel of truth. Any data point has the potential to create huge swings and changes in direction, overreactions thus become far more likely.
• Why are markets so sensitive to data that would normally be regarded as merely an imprecise guide to the economy, to be taken in the context of other reports?
  • First, the Fed is watching the data so we should too. Jerome Powell, chair of the Federal Reserve, has made clear that the Fed is looking at reported figures, rather than relying on its models. It hasn’t been since the early 1990s that interest rates have been so influenced by the economic data that comes out between Fed Meetings. Since interest rates are themselves having an outsize effect on markets, the data thought to be influencing the rates should move prices a lot too.
  • Second, liquidity is terrible. A mix of volatile markets and tighter monetary policy has made traders and market makers less willing to take risk, which means prices move more on bursts of buying or selling. Bond volatility as measured by the ICE BofA MOVE index (measure of U.S. interest rate volatility that tracks the movement in U.S. Treasury), reached an all time high amid last weeks U.K. chaos (the promise of huge unfunded tax cuts sparked turmoil in financial markets and sent the British pound tumbling to a record low against the U.S. dollar) not seen since the first pandemic lockdown in 2020, and before that the financial crisis of 2008-2009.
  • Third, there is a general fear of something breaking thanks to the Fed tightening, which makes everyone much more focused on the short term and much more sensitive to any potential problems. Last week the British government bond market crashed and had to be saved, and unfounded online rumors on Monday hammered Credit Suisse’s (a leading financial services company) shares and bonds.
• There can only be theories, though, and none is entirely satisfactory. As long as everyone else is focused on economic data, anyone who cares about short-term performance needs to pay close attention to the data too. At the very least, investors should recognize the inherent unreliability of any given economic report, and the risk of market overreaction.

II. Figures