Stock market bears start to argue the Goldilocks economy is running too hot

Russ Mould
9 October 2018

“One huge part of the bull case for the US stock market is that the American economy is in a ‘Goldilocks’ phase: not so cold that it threatens to slow healthy corporate profits growth but not so hot that it forces the US Federal Reserve into raising interest rates more quickly than expected,” says Russ Mould. “However, this argument is now being tested. The yields on US Government bonds, or Treasuries, are rising sharply and doing so in a way that means the so-called yield curve – the difference between the yield on the 2 and 10-year Treasuries – is now steepening as 10-year yields rise faster than 2-year ones. 

Source: Thomson Reuters Datastream

“This makes the third-quarter reporting season in the USA all the more important and this will begin in earnest on Friday with numbers from the megabanks Citi, JPMorgan Chase and Wells Fargo.

“A strong third-quarter season, with plenty of upgrades for the fourth quarter, may soothe some nerves, but any stumbles and disappointments could leave investors more confused.

“The sudden spike in Treasury yields and steeper yield curve may deal with prior worries over an inverted yield curve, where the 2-year yield exceeds the 10-year, a development which is often seen as a warning of imminent recession (even if the 0.34% yield premium on 10-year paper relative to 2-year is still very skinny).

“But it still offers a challenge to share prices, as investors switch from worrying about the US economy cooling to concerns that it could run too hot. This just goes to show what a delicate balancing act the US Federal Reserve must carry out as it manages interest rates going forward, although chair Jay Powell has made it clear on several occasions that the primary concern of the Federal Open Markets Committee is meeting the central banks twin mandates of inflation and employment, not helping people make (or avoid losing) money in the markets.

“Even if the ‘Goldilocks’ theory eventually came unstuck in 2000 and 2007 (yes, experienced market watchers have heard this one before), the steeper curve does not guarantee that the long-awaited stock market correction is upon us, but it does raise the risk of an accident.”

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