Wednesday's bullish news conference from Federal Reserve chief Jerome Powell sparked the biggest gains for the Dow Jones and S&P 500 since 2020, while the Nasdaq composite climbed out of bear-market territory. A day later, all of those Dow and S&P gains have been erased, and a bear is once again stalking the Nasdaq.
The simplest explanation for the stock market's overnight U-turn is that the Dow Jones has what might be described as a Catch-2022 problem.
Like the predicament facing the protagonist in Joseph Heller's famed 1961 satirical novel "Catch-22," the only way to solve the problem also ensures that there can be no resolution.
Why Powell's Message Buoyed — Then Sank — The Dow Jones
The Dow's predicament is that the Federal Reserve has to tighten policy so far and so fast that it risks triggering a recession. The way out is a less-hawkish Fed, and Powell seemed to deliver that on Wednesday, fueling a rally.
All it took was for Powell to take the possibility of a 75-basis-point rate-hike off the table, at least for the June meeting.
If a somewhat less-hawkish Fed can still adequately tame inflation, the Dow Jones is set to rally.
Yet, as Powell has explained recently, monetary policy "reaches the real economy" by changing financial conditions, such as market-based interest rates and stock prices.
In other words, seriously tightening policy and doing it "expeditiously," as Powell has said is needed, almost implicitly requires lower stock prices.
Just how low is far from clear, but Wednesday's 1,000-point Dow Jones rally probably wasn't what the Fed is looking for.
Just a hint of a dovish Fed helped send the 10-year Treasury yield to a new cycle high of 3.1% on Thursday, closing up 15 basis points to 3.07%. Meanwhile, the Dow Jones Industrial Average tumbled more than 1,000 points, or 3.1%. The S&P 500 plunged 3.6%. The Nasdaq dived 5% after hitting its worst levels since 2020 intraday.
The Dow's Catch-2022 problem, though, isn't as entrenched as Capt. John Yossarian's Catch-22. Eventually, inflation pressures may subside enough for the Fed to relax its hawkish talons. But for a good part of 2022, the Dow's path higher may create its own downdraft.
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Does Federal Reserve Tightening Require Lower Stock Prices?
The Fed may have its own Catch-2022 problem, as well. The reason why Fed policy may not produce a recession is also the reason why it may not be able to avoid a hard landing.
As Deutsche Bank strategist Jim Reid wrote in his Thursday morning commentary, Powell sought to provide assurance that the Fed can achieve a soft landing, because business and household finances are strong enough to withstand a significant tightening in monetary policy.
Yet "that very strength when inflation is at multi-decade highs is why policy will probably need to reach restrictive levels not currently appreciated by market pricing," Reid wrote.
The first test of Powell's soft-landing outlook comes with Friday's jobs report. On Wednesday, Powell said he thinks the unemployment rate is close to a bottom because labor force participation is on the rise and job creation will slow. Any further decline in the unemployment rate will be "relatively limited," he said.
Wall Street economists expect Friday's jobs report to show that the U.S. added 400,000 jobs in April and the jobless rate held at 3.6%.
