Wall Street used to view weak economic data as good news – why that has changed

Starting in 2022, around the time the Federal Reserve began raising interest rates to combat rising inflation, a new paradigm took hold on Wall Street: “bad data” was good news.

The U.S. economy grew by nearly 7% annually at the end of 2021, the fastest pace in two decades – excluding the Covid-related 33% increase in the third quarter of 2020. US consumers, the engine of the US economy, spent outrageously after emerging from the Covid lockdowns with huge savings.

But the economic boom was a double-edged sword. From January to December 2021, the annual inflation rate climbed from 1.4% to 7%. It was expected to continue rising until it peaked at 9.1% in June 2022, the highest level since the 1980s.

The Federal Reserve focused on inflation and launched its most aggressive interest rate hike campaign in decades in March 2022 to prevent the U.S. economy from boiling over.

Despite the US Congress's mandate to keep both inflation and unemployment under control, the Fed may focus on a single target due to historically tight labor market conditions.

Hiring stalled in March 2020 when Covid-19 forced businesses and offices to close nationwide. But as the economy recovered and low interest rates spurred growth, companies embarked on a hiring boom. In 2021, employers created an average of 603,000 new jobs per month, bringing the unemployment rate down from 6.4% in January to 3.9% in December. And yet, as of March 2022, there were still over 12 million job openings in the United States, almost twice as many as before the pandemic.

The labor market remained unusually tight in 2022 and 2023, with wage growth well above the pre-pandemic average and subsequently supporting consumer spending and growth.

And so, for a while, signs of a weakening labor market and slowing economic growth were good news for the Fed and the markets, because inflation was the Fed's biggest risk.

Inflation is no longer the main concern

That has all changed in the last few weeks.

In early August, stocks had their worst day since 2022 after the July jobs report showed a surprise increase in the unemployment rate, raising fears that the labor market had not only slowed but worsened and the economy was heading for a recession. Just days later, initial jobless claims came in lower than forecast and stocks had their best day since 2022.

Inflation has taken a back seat to other economic data. According to a recent report from Bank of America Securities, the S&P 500 reacted the most to growth data since 2020 earlier this month. At the same time, the index's reaction to inflation data was the weakest since January.

“Growth,” BofA analysts concluded, “is in the driver’s seat.”

And strong growth no longer scares markets, as shown by the following visualization from LPL Financial strategists Adam Turnquist and George Smith, who charted the correlation between the S&P 500 and the Bloomberg US Economic Surprise Index. A positive correlation, they note, means that good economic news is good news for Wall Street, while a negative correlation means the opposite.

The two have fluctuated between negative and positive correlation over the last year, with a longer negative correlation. The negative correlation was also larger at its strongest than the positive correlation at its strongest.

In early August, the correlation turned positive, which Turnquist and Smith said could be a sign that “investors may no longer be giving the economy the benefit of the doubt.”

Fed increasingly focuses on the labor market

The Fed has also stopped giving the economy the benefit of the doubt. “The economic outlook is uncertain, and the Committee continues to monitor inflation risks closely,” the Federal Open Market Committee's monetary policy statement from June said. In July, the sentence read: “The economic outlook is uncertain and the Committee is aware of the risks for both sides of its dual mandate.”

Minutes of the Fed's July meeting, released on Wednesday, show that central bankers are increasingly concerned about the state of the labor market. According to the minutes, “participants saw the risks to the achievement of inflation and employment goals becoming more and more balanced, and some noted that they viewed these risks as more or less balanced.”

On Friday, Fed Chairman Jerome Powell said in a highly anticipated speech at the Fed's annual economic symposium in Jackson Hole: “Upside risks to inflation have diminished. And downside risks to employment have increased.” As a result, “the time has come to adjust policy,” Powell said, noting that the pace of monetary easing will depend on upcoming data.

Markets nervous ahead of interest rate cut in September

Wall Street has been waiting impatiently for interest rate cuts for much of the year, but now that those cuts finally seem imminent, they could also seem threatening.

“Does the market really want the Fed to cut rates because it's worried about the labor market?” asked Quincy Krosby, chief global strategist at LPL Financial. To some extent, yes, “because what the market doesn't want is for the Fed to neglect this – to just watch the labor market deteriorate and do nothing about it.”

“But,” she added, “it also suggests that the economy is slowing faster” than the market thought.

What markets really want, BofA analysts argue, is reassurance that the central bank will not sacrifice economic growth to curb inflation. “Equity markets just need a sign that growth is supported by the Fed,” they write.

Whether the Fed will budge will depend, in the words of Fed Chair Powell, on “the totality of the data.” And there is a lot of data to expect between now and the Fed's next meeting on September 18 – two separate inflation reports and the August employment report.