Making sense of market uncertainty

The latest FOMC statement and subsequent press conference were full of references to “uncertainty”. Most notably, the FOMC statement changed the language related to the Fed’s goals being “roughly in balance” to “uncertainty around the economic outlook has increased”.

 

Not only is uncertainty elevated, but also the risks to inflation, GDP growth and employment have risen in 2025, which increases the odds of stagflation ahead.

How should investors react to the increase in policy uncertainty?
 

 

An Uncertain Federal Reserve

Let’s start with how the Fed has reacted to current economic and market conditions.
Fed Chair Powell expanded on the Fed’s uncertain outlook during the press conference by referring to weakness in the soft, or survey data: “Surveys of households and businesses point to heightened uncertainty about the economic outlook”.

On the other hand, the hard data is holding up well: “We see pretty solid hard data still. Consumer spending moderating a bit but at a solid pace. Job creation healthy. Inflation has started to move up partly due to tariffs.”

Powell added that the Fed is in wait-and-see mode to see whether the hard data will follow the weakness in soft data: “The relationship between expectations or survey data and hard data hasn’t been that tight. We’ll be watching for signs in the hard data closely. We think we need to wait here for further clarity.”These comments put greater noise around the dot plot. While the median dot plot maintained expectations of two rate cuts in 2025, the ranges of the expected rate path increased 0.3% in 2025 and also rose in 2026.

In actual fact, investors should regard the dot plot as nothing more than speculation. One key announcement in the near future is the report on reciprocal tariffs, which is scheduled for April 2. If the Treasury Secretary hasn’t even seen the numbers on what could be a large tariff-based tax hike on April 2, how much weight should investors put on FOMC guesses?
 

 

In the wake of the FOMC announcement, the market has maintained its expectation of three quarter-point rate cuts in 2025. In light of all the uncertainty surrounding the inflationary effects of tariffs and00 the Fed’s reaction function to tariff-related changes in price levels, the risk of disappointment is high.
 

 

As a reminder of the effects of a trade war, Bank of Canada Governor Tiff Macklem warned, “Depending on the extent and duration of new U.S. tariffs, the economic impact could be severe.” More importantly, “Monetary policy cannot offset the impacts of a trade war.”

In other words, the effects of a Fed Put is limited if a full-blown trade war were to erupt.
 

 

The Market Reaction

The market reaction to rising policy uncertainty has been highly bifurcated. In the past, spikes in economic policy uncertainty (blue line) have been accompanied by spikes in junk bond yield spreads (red line). This time, credit market risk appetite remains relatively calm and shows few signs of panic consistent with historical norms.

 

By contrast, the trade war risk factor in the U.S. equity market has been rising steadily.
 

 

The latest BoA Global Fund Manager Survey shows that observations about the equity market reaction are further obscured by the cross-current stampede out of equities, and U.S. and tech (read: Magnificent Seven), into non-U.S. markets.
 

 

Who is right? The credit market or the stock market?
 

 

Waiting for the Hard Data

For the definitive verdict, investors and policy makers will have to wait for the hard data to confirm the weakness in the soft survey data. However, my expectation is the hard data will follow the downward path of the soft data.

Consider how uncertainty affects the economy. Businesses put their expansions on hold, which slows growth. Households become uncertain about employment and put spending plans on hold.

New Deal democrat, who has kept a watch high frequency data, recently made a study of the relationship between policy uncertainty, business spending and consumer spending. He found that “when we look on a YoY basis quarterly, you can see that significant changes in policy uncertainty (blue line, inverted) lead new orders for goods (red and gold lines) by an average of two to three quarters.”

 

On the other hand, “The consumer response appears much more coincidental to episodes giving rise to more uncertainty, lagging on average only one quarter and sometimes not at all.”
 

In conclusion, investors need to believe President Trump and Treasury Bessent’s message of short-term pain for long-term gain. Already, the Economic Surprise Index, which measures whether economic data is beating or missing expectations, is deteriorating. This, along with the weakness in survey data like consumer confidence, is foreshadowing a slowdown. It remains an open question whether the economy will actually fall into recession.
 

In the short run, stock prices are rebounding from an oversold condition in response to the sanguine reaction of the credit markets to policy uncertainty. Longer term, equity investors have to be prepared for a deterioration in the growth outlook, which is bearish for equities.