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Markets Are Stuck In Overreaction Mode
Every little data point has the potential to create huge swings and changes in directions
By James Mackintosh
Investors are behaving like sugar-starved children offered a lollipop, grasping for it with delight only to scream when it is taken away again.
On Monday, the sweeties came in the form of some mild bad news on the economy. The Institute of Supply Management’s manufacturing index came in a little weaker than forecast. This prompted an extraordinary rush to buy bonds and stocks as bets mounted that the Federal Reserve would raise interest rates less aggressively.
The sugar rush lasted into Tuesday, with bond yields continuing to fall and stocks starting well, boosted by falling job openings, a sign of a weakening labor market.
The trouble is that single data points contain little of lasting nutritional value for the markets. The markets risk a tantrum if the lollipops are once again confiscated, as has happened several times in the past few months. Worse still, 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.
There is a good reason why economic data have gained importance over other factors in moving markets. Investors have a well-founded fear: 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.
That is reasonable, but the problem is that economic data swing about from month to month, while the market treats them as gospel truth. Any data point has the potential to create huge swings and changes in directions. Overreactions thus become far more likely.
Monday’s move was big for such a small shift in the ISM. Benchmark 10-year Treasury yields dropped by 0.15 percentage point, taking equal-second place for biggest fall of the year behind only last Wednesday, when the Bank of England unexpectedly started to buy government bonds. The S&P 500 leapt 2.6%. Compare that with the ISM report at the start of July, which missed the consensus forecast by more than on Monday, but only led Treasury yields to drop half as much, and stocks to rise 1%.
“The drop in Treasury yields is breathtaking,” observed Jonathan Golub, chief U.S. equity strategist at Credit Suisse.
Just as extreme were the moves in the other direction in June and September on the back of slightly-higher-than-forecast inflation figures. In June, the surprisingly high inflation led to a heavy two-day selloff. In September, inflation was reported at 8.3% instead of the forecast 8.1% and stocks cratered 4.3% on the day, as two-year yields jumped 0.19 percentage point.
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? Here are three theories:
First, the Fed is watching the data, so we should too. Fed Chairman Jerome Powell has made clear that the Fed is looking at reported figures, rather than relying on its models. Not since the early 1990s have interest rates been so influenced by the economic data that come 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. Prices are expected to keep swinging around, too: The implied volatility of U.S. bonds, as measured by the ICE BofA MOVE index, reached a high amid last week’s U.K. chaos not seen since the first pandemic lockdown in 2020, and before that the financial crisis of 2008-09.
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 cracked and had to be saved, and unfounded online rumors on Monday hammered Credit Suisse’s shares and bonds.
“Nobody wants to take risk in this environment because one little tweet or one little downdraft can create chaos,” said Vineer Bhansali, founder and chief investment officer of Newport Beach-based hedge fund Longtail Alpha. “When stuff’s going down no one wants to get in front of it.”
These can only be theories, though, and none is entirely satisfactory. But so 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, though, investors should recognize the inherent unreliability of any given economic report, and the risk of market overreaction. Lollipops are nice, but don’t provide real sustenance.
