A Benign Market Environment for Economic Recovery

April 26, 2010

Yes, you read my headline correctly.  This certainly has not been true about Greece, and financial markets in other peripheral members of the common currency bloc are at risk.  But the statement does fit the situations pretty well for key advanced economies such as the United States, Germany, Britain, and Japan.

  • At noontime in New York today, the S&P 500, DJIA, and Nadaq stock indices showed year-to-date advances of 9.1%, 7.7%, and 11.9%.  The ten-year Treasury yield was 4 basis points lower than its end-2009 level, and the trade-weighted dollar had risen by an innocuous 1.5%.  A third of 2010 will be finished at the end of this week.
  • The German Dax shows a net appreciation of 6.3% on the year and is 9.1% higher than its first-quarter average level.  Ten-year bund yields have declined 34 basis points since the end of last year, and a 5.8% depreciation of the trade-weighted euro has boosted German competitiveness further.  Preliminary April purchasing manager readings reflected the stimulus caused by the softer euro.
  • The British Ftse has improved 6.3% so far this year in spite of political uncertainty and a more tepid economic recovery than in many other G-7 economies.  Ten-year U.K. gilt yields are 3 basis points lower than at the start of 2010 in spite of Britain’s double-digit deficit ratio.  The trade-weighted pound has slid 1.4% additionally after a sharp depreciation in the second half of last year.
  • The Japanese Nikkei is 5.9% higher than its 2009 closing level.  Japan’s debt has surpassed 150% of GDP, and the government will borrow more money this fiscal year than it will raise through taxes.  The ten-year JGB yield is nonetheless only 1.33%, a mere three basis points greater than at the start of 2010, and the trade-weighted yen is nearly 3% weaker than its first-quarter mean value.

Global and even advanced economies have reported better economic activity this year than anticipated for the most part.  Higher commodity prices have lifted input price inflation in Europe according to the April PMI surveys and allowed Japanese deflation to flatten.  The central banks in the G-7 haven’t yet raised benchmark interest rates yet, but many unconventional quantitative steps taken during the financial market emergency have been ended or suspended.

Properly functioning financial markets help keep governments honest.  Sometimes they do, sometimes they don’t, and sometimes they overreact.  After the Fed began a tightening cycle in early February 1994, the 10-year Treasury yield advanced from 5.73% initially to 7.41% by May 12 that year and 8.03% by November 7.  During the last U.S. monetary tightening cycle, the 10-year yield was at 4.62% at the beginning in mid-2004 and again around that same level in late March 2005 but at 5.24% by the last rate hike in June 2006.

Investors can be confident about the economic recovery because data continue to outperform forecasts more times than not.  Additional confidence resting on the the benign behavior of financial markets in response to signs of recovery can actually create feedback with further real economic stimulus.  If one is not Greece or Portugal, markets are so far not making the governments pay for their lunch, and the unheeded warnings about unsustainable fiscal trends in Japan, Britain and the United States exhibit a tired boy-crying-wolf aura to varying degrees.  Some time ago, CDOs were considered a financial market device that reduced systemic risk.  Others treated the U.S. current account deficit as the necessary residual that results from the success of attracting so much foreign capital, and a nationwide housing sector recession was assumed to be an impossibility by many people.  Market misjudgments like these undercut the premise of rational expectations.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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