'Bad Goldilocks' Economy Puts Fed, Markets in a Box

"Bad Goldilocks" means the recovery is neither hot enough to inspire confidence nor cold enough to drive Fed intervention.

Fear of the policy quandary is keeping many investors on the sidelines.

Not too hot and not too cold — that used to be the recipe for the so-called Goldilocks economy, but lately has become the calling card of its evil twin.

Source: DC Wiki

In the era of historically large central bank interventions, the economy must now deal with "Bad Goldilocks," a condition in which the recovery is too little to make a pronounced impact but remains just strong enough to keep the Federal Reserve on the sidelines.

And since the onset of the financial crisis, any sign that the Fed may back off from quantitative easing stimulus has been poison for the markets, which have been struggling as of late.

"We see risks of a 'bad Goldilocks' backdrop to financial markets in which the economy is neither 'cold' enough to provoke the quantitative easing that risk assets are now so cravenly dependent upon, nor 'hot' enough to provoke losses in bonds that would inspire a wholesale rotation out of fixed income into equities and commodities," Michael Hartnett, chief global equity strategist at Bank of America Merrill Lynch, wrote in a recent note to clients.

With the Fed set to meet next week, and as its Operation Twist selling and buying of bonds about to expire in June, the central bank's response to a fragile economic recovery will be crucial for investors.

"The bullish drivers of risk assets since October are likely to fade. No longer can the economy only surprise to the upside. No longer is positioning in asset markets dangerously bearish. And policy stimulus will be less potent for risky assets," Hartnett said. "We doubt the 40 rate cuts and over $1 trillion of asset purchases by central banks in the past six months are likely to be repeated in coming months."

Despite a strong percentage gain in the stock market since the October lows, investors have been loathe to participate on a broad scale.

Money continues to pour out of money market and stock-based mutual funds and into bonds, while stock market volume is down 23 percent from its 2011 levels. Investor fear remains that the European debt crisis is about to accelerate, while U.S. economic data has been making a less-than-convincing case for a robust recovery.

"There's this sense of deja vu that people have, where we've seen this movie before where things start to look a little better then they slip back," said Josh Feinman, chief global economist at Deutsche Bank Advisors in New York. "It makes people cautious about having much conviction. They're almost waiting with a palpable sense of foreboding that things are going to get worse again."

In a recent series of meetings with European clients, JPMorgan Asset Management strategists found an equal level of worry overseas.

Investors abroad worry that political roadblocksin Washington also pose threats, and the Fed itself often has found itself at the center of the storm.

This, then, is where "Bad Goldilocks" becames especially prevalent and pernicious — the Fed is prevented from taking strong actions because of political concerns, even as widespread worry over the pace of recovery looms large in the presidential electionyear.

"Investors just do not want to get caught again in this 'slope of hope' market where political grandstanding by both parties causes big sell-offs in markets (probably to political advantage)," said JPMorgan's chief market strategist Thomas J. Lee. "Thus, the best action is no action. The implication is that political events in 2012 will again take center stage at some point. And markets tend to not behave well when their fate is in the hands of politicians."

Politics at the Fed? Ostensibly the central bank is supposed to operate above the wranglings on Capitol Hill and issue policy in strict accordance with its dual mandate of full employment and stable prices.

Yet Michael Pento, an economist and head of Pento Portfolio Strategies, sees the central bank as its own worst enemy, actually doing too much to telegraph policy and thus creating a cycle of dependency on Wall Street.

"Years and years ago, perhaps in the '70s and '80s, you had to guess what the Federal Reserve was doing. Now, it's glasnost at the Federal Reserve and I think it's backfiring on them," Pento said. "Their main goal is to keep inflation expectations under wraps, but every time they make a move to create money they telegraph it as much as possible."

The Fed is in a box, said Pento, who would like the Fed to stop its easing measures. Doing so, though, would result in a sharp economic downturnthat ultimately would lead to a return to fiscal and monetary normalcy, something Pento doubts that the central bank has the collective stomach to endure.

"They need a massive dose of free markets to invade the economy," Pento said. "We haven't had that for years and years. But the transition from a manipulated economy to a market economy is going to be extremely difficult."

In the short term at least, the Fed is unlikely to make any major moves at least until Operation Twist expires or the economy shows a significant downturn — Bad Goldilocks or not — said Deutsche Bank's Feinman.

"Unless things deteriorate in a clear way, the most likely outcome is the Fed more or less stays the course," he said. "They retain the commitment to hold rates low for a long time, then wait and see how things develop. It's kind of boring, but it's probably at this point the most likely outcome."