Markets bounced around a bit last week due to the continued volley between economic/earnings expectations and interest rate expectations. As a market observer, you must fully grasp this dynamic to translate daily volatility.

When economic data comes in better than expected, the market assumes monetary policy will tighten. This drives interest rates up and market P/E multiples down.

Therefore, from a P/E standpoint, good news is bad news. Conversely, better-than-expected economic data implies better-than-expected corporate earnings. Therefore, from an earnings standpoint, good news is good news. The market must decide on a daily basis which has the upper hand.

First Service: Central Bankers

Last week, the Federal Reserve released two studies that advocate reducing the Fed’s unemployment threshold for policy reversal from 6.5 percent to 5.5 percent. Doing this would elongate the timetable for easy money, thereby lowering interest rate expectations.

Additionally, faced with a worrisome disinflation trend, the European Central Bank cut interest rates to .25 percent. These two initiatives lowered global interest rate expectations. On the week, central bank activity should have pushed rates lower. Did they?

Second Service: Economic Data

Global manufacturing activity in October hit its highest level in 32 months. The new orders component rose considerably as well, leading to acceleration in hiring.

These statistics bode well for yearend GDP releases globally. Here in the U.S., our major indicators all surprised to the upside, consistent with the global data. U.S. GDP grew 2.8 percent last quarter, blowing away the 2 percent estimate.

On the heels of the report, the 10-year Treasury rate climbed .13 percent as the economic news overpowered the central bank news. With rates higher on the week, stock prices should be lower. Were they?

Match Point

The markets judged the bad news from the rate-increase as less significant than the economic-increase good news. The S&P 500 closed .50 percent higher on the week in spite of higher rates.

Most likely, the gains resulted from bearish bets reversing field rather than new buying. Nonetheless, the balance of opinion turned optimistic through the course of the week, pushing us again near all-time highs.

Do We Bore You?

For our loyal readers, at this point our obsession with the interest rate wiggles might bore you. We could certainly shift to other variables to mix things up.

However, if there is one thing we have learned trying to harmonize forecasts with reality, it’s this: In every intermediate market period, one variable trumps them all. In the 1990s, it was irrational expectations; in the 2000s it was financial engineering; today its central bank policy.

Looking back over the last five years, correctly forecasting Fed policy direction resulted in correctly forecasting the markets direction. “Low short-term and long-term interest rates for an extended period will force P/E ratios higher.”

That single narrative describes the last five years. Should valuations peak, or interest rates and inflation expectations rise, the narrative will shift. A shift in the narrative portends a shift in trend. Keep your eye on the ball.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.