We are still under the spell of the liquidity events surrounding the pandemic. Between Federal Government spending and the Federal Reserve actions (two different kinds of stimulus: one monetary, one fiscal),  investors got used to markets that bounce up and beat the drum like the Energizer Bunny.

I maintain that there were three confluent bubbles in place: the Trump trade, the Fed trade, and the AI trade. Right now, the Fed Trade and the AI trade appear to dominate the narrative as markets  reflect “squeezy” conditions where hedge funds have been too quick to bet on the downside and  with continued upside action are forced to buy back in.

I read a headline a few weeks ago  implying that individual investors are driving the push upward. I have seen this before at least two times in my career: The Tech Bubble or Dot.com Bubble of 2000 and the Real Estate Bubble of 2009. It’s nothing unusual because investors–amateur and professional–don’t really know what new technologies (like AI) will ultimately bring, so they use momentum strategies and focus on trend. The result is likely to be seen in hindsight as price overshoot: the fear of missing out (FOMO) is real at all levels. It is difficult to predict the duration of these events as they are driven by emotion, by herd behavior (note: the media doesn’t help).

But the disconnects I refer to are primarily between the bond market and the stock market. In the past week and despite inflation fears, bond prices have made a short-term surge higher, sending interest rates sharply lower. The apparent driver was data revealing a slowing economy. Yet stocks stayed on their upward course, setting fresh records with each new thrust. This sounds like the old “bad news is good news” theme again, which focuses more on the cure (lower future interest rates) than the malady (a weak economy, a tiring consumer, and lower corporate earnings).

Yet the inflation genie is not yet back in the bottle, so how do we know that even with a slowing economy the rate cuts will be curtailed due to latent inflation pressures from tariffs? And in the past, when the economy stumbled, the Fed used QE, it’s bond-buying program, to try to lower long-term rates (e.g. mortgage rates) and provide liquidity for Wall Street and Real Estate. However, there remain excess trillions worth of bonds on the Fed balance sheet from the pandemic-related QE and guess what? –the Fed is still trying to shrink that down each month!  My point is that I highly doubt this time the Fed will come riding in as it has before with  guns blazing, printing money and sending short-term rates to near zero.

The “Buy the Fed policy trend” narrative will likely fizzle, leaving only the AI narrative (and the limited number of those players) to try and prop up the current index levels.

Something’s gotta give: either a) bond prices will fall back down (and rates go back up) with inflation worries, or b) stocks will fall when the economic weakness hits earnings, or c) bonds and stocks will both fall due to stagflation–the economic nightmare where we enter the doldrums of low growth plus high prices and can’t stimulate our way out of it.

WRH