Never Underestimate the Power of Fear Itself

October 15, 2014

These are fearful times for financial markets and the general public.  It’s much easier to believe in Murphy’s Law that if something can go wrong it will than to dismiss the recent market swings as fleeting hysteria that will self-correct because economic trends are fundamentally sound.  The list of stress points is lengthy:

  • Euroland is in a cycle of in-and-out recession and now in danger of developing deflation.
  • Japan’s escape from negative inflation could still prove temporary.  The swing above zero was promoted by rising energy prices, yen depreciation, and economic expansion.  The influence of these factors has stalled or reversed.
  • Even though the global economic outlook has weakened, Federal Reserve officials are not expected to willfully abandon plans to begin normalizing short-dated interest rates some time during the first half of next year.  The U.S. economy’s ability to tolerate interest rate normalization constitutes a big uncertainty even if done in a solid economic environment.  The transition of Fed policy now appears fraught with even more downside potential.
  • Russian foreign and domestic policy is in full back-to-the-future mode under Vladimir Putin’s leadership.
  • The U.S. presidency as an institution hardly ever does well in second term administrations. That’s the kindest spin one can put on President Obama, who these days seems unprepared psychologically or skill-wise to play the difficult hand that’s been dealt him.  2014 feels a little like 2008 and even bears some distant resemblance to 1932.  Unlike those years, there isn’t a presidential election.  All the congressional election will accomplish is an even more-stalemated and ungoverning public sector.
  • Bad economic ideas continue to influence policy not just in America but all across the world.  Reunification of Germany now looks like a mistake, given Berlin’s obstructionist role in the European Economic and Monetary Union.
  • Diverse central bank thinking aired in public under the guise of transparency is not a good thing.  It creates investor confusion and weakens confidence that policy timing will be done right.  It would be advantageous if monetary policymakers led, followed or got the hell out of the way.
  • Officials in China did the world economy an enormous favor during the Great Recession, allowing the Chinese economy to be an engine of growth when the West was flat on its back.  It’s hard to find enlightenment in China lately either in economic policy or its conduct in foreign affairs.
  • Way too little is being done to combat climate change.  The likelihood of continuing inattention seems high, and the point of no return will be passed sooner than realized.
  • The Ebola epidemic has many elements to amplify raw market fear: exponential growth, randomness in target selection, and prolific killing power.  Ebola may be nature’s answer to climate change, since excessive world population generates unsafe demand for energy.
  • The increasingly skewed distribution of income and wealth in America causes average economic statistics to overstate the sense of well-being.  The class, racial, and regional divides are more prominent than any sense of one nationhood, which is vitally important to rally behind efforts to combat a common foe, whether that be disease or terrorism.  National identity seems weaker in America than in potential enemies and allies.

The dollar’s appreciation since midyear has fed off the assumption that Fed tightening is coming soon.  Opinions differ among market players on the timing but confidence is pretty universal about the inevitability of a rising fed funds rate in 2015-7.  Policy normalization has in fact been underway for some time, and higher interest rates are the logical next step.  The confidence in such a scenario still looks way too smug.  Consider that benchmark central bank interest rates have not exceeded 0.5% since March 2009 in the U.K., May 2013 in the euro area, September 1995 in Japan and December 2008 in the United States.  Virtual zero rate policies have already far outlasted expectations.   Inflation hasn’t reared back in contrast to forecasts of the Fed’s severest critics.  On the contrary, the U.S. and world economies are currently much more disinflationary than inflation-prone.  Consider too that in less than four weeks since September 19, the S&P has tumbled over 8.5%, and 10- and 30-year Treasury yields have tumbled 59 and 50 basis points.  Commodities are plunging, too, and measures of privately held debt point to surprisingly little progress in the deleveraging. 

The Fed is not going to raise interest rates in market conditions like these.  Even if markets bottom before March, economic activity and demand in the U.S. will not then appear as sturdy as now if current losses in wealth don’t stabilize until much cheaper levels are reached.  But take away the confidence in a tightening Fed policy, and one also loses the main rationale for a strengthening across-the-board dollar.  What happens to bonds and stocks in the meantime will influence the appropriate value of the dollar. 

Franklin Roosevelt’s assertion about having nothing to fear but fear itself implied that fear is a figment of the mind and somehow not a real force because it can be turned off or on at will.  FDR had a gift for inspiring hope and the additional benefit of inheriting a mess with a mandate from a desperate people to try whatever it took to turn things around.  For Obama, that moment came almost six years ago.  It’s now too late even if he tried to do the right stuff.  The fear on/fear off switch, known in market parlance as risk on/risk off, isn’t under Obama’s control anymore, or easily manipulated by central banks or other governments.  Future data will be key, but the relationship between market behavior and economic data runs both ways.  Investors have tried to cope in a world of extreme uncertainty since the 2007 financial crisis, and that need continues to be a fact of market life that extends to foreign exchange.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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