Stocks And Bonds Rally On Hopes Of The Fed Engineering A 'Golden Path' For The US Economy

After searching for direction on Monday, U.S. equity and debt markets rallied on Tuesday on a new narrative, which sees the U.S. economy on a golden path of lower inflation without a recession.

At 2 p.m., the S&P 500 was at 4,382, up 0.37% for the day; the Dow Jones at 34,152, up 0.17% and the tech-heavy Nasdaq at 13,665, up 1.08%.

Over in the debt market, Treasury bond prices resumed the price gains of the previous week, driving yields lower. For instance, the benchmark 10-year Treasury bond traded with a yield of 4.56%, down from 4.66% in the last session.

The new narrative that renewed the interest of traders and investors on both debt and equities was floated by Chicago Fed President Austan Goolsbee in a CNBC interview on Tuesday morning.

"Because of some of the strangeness of this moment, there is the possibility of the golden path ... that we got inflation down without a recession," he said.

The Chicago Fed president sees such a scenario as a continuation of a modest rise in unemployment and lower inflation the U.S. economy has experienced thus far this year.

That sounds like a Goldilocks or soft landing scenario, an economy that isn't too hot or too cold and an ideal regime for both stocks and bonds.

A modest rise in unemployment takes the pressure off wages that could fuel another round of cast-push inflation without depressing household income and spending, which could depress corporate earnings.

Meanwhile, the decline in inflation is a favorable development for both bonds and stocks. For bonds, lower inflation could help drive interest rates lower across the entire spectrum of the yield curve. For instance, lower inflation could put price expectations lower, pushing 10-year, 20-year and 30-year Treasury bond yields lower. As a result, mortgage rates will follow suit, reviving interest in homebuying.

Moreover, lower inflation and higher unemployment could prompt the Fed to lower short-term interest rates, adding liquidity to the system.

Lower short-term and long-term interest rates and higher liquidity support higher equity valuations.

Still, bullish equity and bond traders fixated on the headline news failed to grasp the rest of Goolsbee's interview where he explained that getting the economy into a "golden path" is a long shot.

"Unusually for a soft landing of this magnitude, there has never been an inflation rate drop to get inflation down as much as we're getting it down without a big recession. That's never happened," Goolsbeesaid said. "Let's shoot to try to manage that."

Melissa Cohn, regional vice president of William Raveis Mortgage, sees the possibility of the Fed succeeding in this endeavor, engineering a soft landing.

"There were some weaker economic data that came out, which is all good for us," she told International Business Times. "Because it may be a sign that the economy is starting to slow down and inflation will moderate at a pace that suits the Fed."

But Steve Rick, chief economist at TruStage, is skeptical. He sees a rocky road ahead for the U.S. economy and the Fed's efforts to drive inflation lower.

"As the economy faces further threats of uncertainty with turmoil in the House of Representatives and an unwieldy yield curve, the Fed's remaining imperative is to bring down inflation swiftly," he told IBT. "As a result, we expect long-term interest rates to remain elevated in the new year and to potentially see more rate hikes, as the Federal Reserve continues their Quantitative Tightening program, reducing their purchases of Treasury bonds and agency mortgage-backed securities."