Capital Markets Update

By Louis S. Barnes                                 Friday, May 15, 2015

After three weeks of startling (and painful) movement, financial markets have staggered to a standstill.

The question before the house: Did the market-lurching signify changes in economic trend, or correction of prior events?

Stick with correction. Here is the reconstruction.

Way back, 18 months ago, US long-term rates were rising fast based on Fed withdrawal from QE and another apparent US economic acceleration. The US 10-year Treasury reached 3.00% twice, mortgages close to 5.00% at New years 2014. Then, in one of the more remarkable patterns of recent times, the 10-year entered a straight-line glide path for 16 months, culminating at 1.90% in the third week of April.

The lurch upward since, into the 2.20s has disturbed a lot of people but should not. The 16-month slide was the work of the US economy doing far better than Europe, hence the Fed shouting intentions to raise its rate while the ECB threatened its first bond-buying QE. By last fall, into winter the central bank divergence had spectacular effect on currency markets, the euro crashing towards 1:1 with the dollar; and as the euro crashed it forced other central banks to undercut their currencies to maintain trade competitiveness with Europe.

The dollar rising versus the world pulled cash into the US, pushing up prices for bonds (their yields down) and stocks. This currency force overwhelmed any market fear of a higher overnight Fed rate.

There were several sideshows during the period, oil in the lead. I argued then and re-state now: the oil decline had far less stimulative effect on the world economy than any previous decline. Prices of natural gas had crashed five years before, instead of simultaneous with oil as in previous oil declines. Same for coal. The primary Western use of oil is for gasoline, and its $3.50/gallon had already been so high (the same price per liter in the rest of the world because of taxes) that that we were already weaning ourselves. “Miles-driven” in the US had not risen since 2008. Optimistic-side economists are still hunting for consumer stimulus, but no Wascally Wabbit in sight.

The oil drop has thickened the cap on inflation, but the fundamental lid has been welded, bolted, chained, and cemented in place for two decades: wages are barely growing. Here and everywhere, same.

The last month’s reversals are just correctives to an overdone fall-winter move. In a beautiful illustration of recurrent technical trading patterns, the US 10-year has now retraced exactly one-third of its 16-month drop. The euro is back to $1.14, and as the dollar has slid, bonds have been dumped, yields up. Some make the truly foolish argument that ECB QE has worked and Europe has righted itself and Euro-inflation is on the way. Nah. Its economies have gotten a boost from the weak euro, which has had the reciprocal effect here, weakening the US.

All of this feels as though global markets have reached a temporary equilibrium. Now we need for something to happen, perhaps several in concert to tell us if the world economy is headed upward, or will drift back into the long-term disinflationary goop.

Everything I can see says the latter. Nothing grim: big demographic shifts not far ahead will diminish the oversupply of labor, and then add to its compensation. But in the meantime the whole world is trying to rig the game in favor of its exports. Except us, of course, maybe-maybe-not able to get TPP off the ground — and TPP is not a table-tipper, just a balancer.

Persistent QE in Europe and Japan, and its residual here I suppose could produce some kind of stagflation, but it’s not likely. Every nation is trying in varying degrees of desperation to keep its people at work, to service overgrown debts both public and private. That effort could not be more deflationary, and the central bank QE cash has little effect except competitive currency devaluation.

And the Fed is on hold, its forecasts in flinders.