Stock Market is Humming Along While the U.S., Japan and Euro-Zone GDP Growth Rates are Negative

We had an interesting observation yesterday, February 14, 2013:  Newswires announced that the euro-zone's economy shrank last quarter at the fastest pace since the height of the recession in early 2009, at an unexpected 2.3% annual rate.   I think this is clearly bad news.  Germany’s GDP is down 2.3%, Spain’s 2.8%, and Italy’s 3.7%.  This is the fifth consecutive decline for Europe.  Meanwhile, Japan’s GDP is also down 0.4%.  This is the third straight quarterly decline for Japan.  The last reading on the U.S. GDP was also negative.

We have other bad news yesterday.  Unless the Congress intervenes, more than $1.2 trillion in spending cuts over the next 10 years are expected to begin March 1 under sequestration.  The House Republicans announced yesterday that they will not intervene to stop sequestration unless the Senate Democrats act first.  This led JP Morgan Chase to reduce its forecast of the U.S. growth rate for 2013.

What was the stock market reaction to all that?  Well, we had a whole bunches of bad news, but S&P 500 index actually finished the day, up 1.05 points to 1521.38.  The stock market just hums along, flirting with all-time-record levels.  This calls for a pause.  Clearly, the stock market is not thinking what I am thinking.  The sudden sharp slowdown is Europe and Japan and hundreds of billions in spending cuts cannot be good news for the U.S. economy, right?   If so, then what is the market thinking?

One possible inference is that the weakness in Europe will keep the easy money flowing for longer in the U.S.  Flow the easy money does.  U.S. Federal Reserve has recently announced that until unemployment falls to 6.5% (as long as inflation stays below 2.5%), it will keep buying Treasuries to keep short term interest rates anchored around zero percent.  As a consequence, Fed’s most recent balance sheet has now exceeded $3.1 trillion.  We are deeply in uncharted territory here.

Clearly, a lot is riding on Ben Bernanke’s shoulders.  He needs to make really really sure that inflation does not rise above 2.5% while he is further expanding the money supply into uncharted territory.  If inflation exceeds Fed’s maximum tolerance point (whatever it is), we could have an ugly monetary contraction saying hello to an unattractive fiscal contraction and an unpleasant GDP contraction.  I am not sure that the stock market will still be smiling in that scenario.  For that, we will need to wait and see.  For the time being though, just be happy and don’t worry.