Tuesday 20 February 2018

Markets fail to get worked up by US impasse

Traders work on the floor of the New York Stock Exchange - the markets haven't got worked up by the US impasse
Traders work on the floor of the New York Stock Exchange - the markets haven't got worked up by the US impasse

James Saft

The interaction of financial markets and debt standoff in the US shows how by worshipping markets, we've crippled them.

Stan Collender, a former staffer on both the house and senate budget committees, sees a 25pc chance that the debt ceiling will not be raised in time, which implies a slightly lower chance of default or partial default.

This is not mild stuff: a US sovereign default is the market equivalent of frogs raining out of the sky and zombies cruising the shopping centres.

"In the event that a debt limit impasse were to lead to a default, it could have a catastrophic effect on not just financial markets but also on job creation, consumer spending and economic growth," the US Treasury said in a report.

"Credit markets could freeze, the value of the dollar could plummet, US interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse."

Now that analysis is obviously part of a political negotiation, but it's also not far off the mark.

And yet, look at markets: Stocks are off mildly, with the S&P 500 only about 2pc off its recent highs. The Vix, the so-called fear index, has risen sharply in the past week, but is at levels that – if viewed historically – don't indicate anything approaching panic.

Treasuries too have been calm, with some indications that investors are positioning themselves for the possibility of a near miss, but nothing extreme.

Well it might be because we cynically think the two sides will reach a deal before the zero hour, but I doubt it. While equities are showing sensitivity to debt-negotiation news, they simply aren't that galvanised by it.

Markets aren't reacting to the story because markets just don't work any more. We have become so obsessed with inflating false wealth through markets that they no longer function properly and can no longer send us meaningful signals.

Throughout the crisis and its aftermath, all manner of policies have been justified or put in place in order to stop markets from falling, or to eke out some economic activity from the wealth effect, the portion of paper gains which finds itself recirculating through the economy. Anything to keep the market happy and buoyant. Unfortunately, while those policies work on markets, they've not worked so well on the underlying economy.

Exhibit A in this phenomenon, and how it is working right now, is the Federal Reserve's decision to delay (or abandon) the taper in September. That was taken in part because the US central bank feared the economic impact of the budget impasse. And while they were correct to do so, repeated attempts to cushion markets from negative economic news has conditioned investors to believe in a "heads I win, tails the Fed eases" world.

The market believes in the Bernanke put more than the Washington default shuffle.

There are two main implications that flow from this analysis.

First, it is not wise to believe in prices, which give a washed-out reading of the risks involved. That in part may explain the huge gap between high equity prices and low corporate investment. Usually you would expect high investment during times of rising and high equity prices. Executives themselves aren't taking the normal signal from public markets.

Second, there is more of a chance of a default because the public markets provide less accurate feedback to lawmakers and voters about the nature of the risks they face. We also won't see the kind of early warning signs of trouble that often bubble up through financial markets. They simply won't be there.

A default, if it comes or if it comes to be anticipated, will be good for longer-term treasuries and bad for virtually everything else. As a default is about gridlock rather than ability to pay, and as treasuries get riskier but will remain the safest investment on the planet (scary thought), large investors will rebalance away from other assets to maintain their overall risk profiles.

If we do get a default, all the volatility that has been suppressed, all of the price action that has been dampened, will come out in one great bang.

If not, it will be saved up for another event. (Reuters)

Irish Independent

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