U.S. equities notched new record highs on Friday -- but perhaps not for the reasons many investors think.
The gains, which ends a two-month stasis near the 21,500 level on the Dow Jones Industrial Average, came despite uneven big bank earnings, disappointing retail sales growth and a decline in the inflation rate to the weakest level since October.
Investors zeroed in Federal Reserve Chairthat interest rates would likely peak at a low level as the central bank continues to tighten monetary policy.
Combined with the weak economic data of late, however, investors seem to think the Fed will be forced to abandon its aggressive policy tightening plans. Those include expectations for another quarter-point rate hike in December and the start of "quantitative tightening" in September, or a reduction of the Fed's $4.4 trillion balance sheet.
In other words, the stock market is moving more in line with the much more gradual pace of tightening priced in by the futures market. And as we've learned time and time again during this bull market, there is nothing that gets the market as excited as the promise of easy monetary policy.
Turning back to the economic data, consumer price inflation fell to a 1.6 percent annual rate from 1.9 percent prior. This missed estimates by a tenth, represented the weakest reading since October, and pulls the measure further from the Fed's two percent target. Retail sales were weak, falling in six of the 13 major spending categories with department store sales down 0.7 percent. Consumer sentiment is cooling off as well, down from a 13-year high in January.
As a result, the odds of another rate hike in December as judged by the futures market fell to 43.1 percent, from 47.3 percent a week ago. And the Atlanta Fed's GDPNow tracking estimate of second-quarter economic growth has fallen to just 2.4 percent, down from a high of more than four percent back in May.
But not everyone is convinced it's a good idea for the Fed to pull back on its tightening plans, if that's indeed how policymakers are going to react to this soft spot in the data. Yellen and her cohorts have emphasized their belief that the pullback in inflation is transitory and driven by short-term factors like recent price competitiveness in cell phone plans.
Bank of America Merrill Lynch strategists released a note to clients on Friday entitled "Take that punch bowl away," effectively pleading with the Fed to continue tightening policy and arguing that the risks to financial stability of letting the market melt higher outweigh the risks of sticking to its tightening plans and removing policy accommodation.
This week's dynamic contrasts sharply with recent Fed commentary focusing, for instance, on elevated asset price valuations and the fact that financial conditions have actually loosened since the Fed started tightening in December 2015. Whether Wall Street can add to its gains later this month will depend, in large part, on whether Fed officials reinforce the market's dovish interpretation or actively works to dispel them. Friday's relatively narrow rally, on light volume, suggests investors aren't entirely convinced one way or another.