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The two great fears driving the stock market

Editor’s Note: Wall Street money manager Doug Dachille last appeared on the NewsHour when the stock market was enjoying spectacular highs. The Dow hit a record 16,000 the day before we spoke with him in November 2013. But records like that, Dachille explained back then, weren’t signs of a healthy market; they were the result of a monetary phenomenon, specifically, stimulus from the Fed. In short, he saw a bubble on Wall Street. (Watch that Making Sen$e segment below.)

Almost a year later, the Dow is still closing above 16,000, but the market looks much more volatile, especially after the Dow took a 460-point dive in Wednesday’s midday trading. The major indexes recovered some of their losses by the closing bell, but Wednesday marked the fourth straight day of losses.

Amid increasing anxiety about Europe’s shaky economy, investors have been selling off risky stocks in favor of government bonds, usually seen as safer. That’s pushed bond prices higher and yields, which move in the opposite direction, lower. As the New York Times reports, American stocks have lost over $2 trillion in value since the peak they enjoyed just a month ago.

Meanwhile, next month, the Fed is expected to end their bond buying program — the program Dachille believes has helped artificially boost asset values. The big fear for Dachille, a trained medical doctor, is that the economy has developed a resistance to the Fed’s therapy, much like antibiotic resistance.

After Wednesday’s wild ride, a Federal Reserve official suggested Thursday morning that the central bank should delay the end of its bond-buying program. That news caused stocks to reverse some of their loses and bonds to reverse some of their gains.

So what’s the market in for? Dachille, who ran proprietary trading for JP Morgan before starting his own firm, First Principles Capital Management, in 2003, identifies two factors that contribute to market volatility and explains why he doesn’t think the Fed will be able to handle the next bout of deflation.

— Simone Pathe, Making Sen$e Editor

There are two primary risks that can negatively impact equity markets. And when market participants perceive changes in the relative likelihood of these risks, market volatility can ensue. The two risks I consider are:

  1. A rapid increase in the real yield caused by a perceived premature tightening of monetary policy.
  2. An intransigent bout of disinflation or deflation.

Domestic policymakers can reverse course if they’ve tightened prematurely, and minimize the effects of their error, but it’s more challenging for them to address disinflation/deflation, and the severity of such a scenario would almost certainly be more catastrophic. Last year’s so-called “taper tantrum” that resulted in market volatility was primarily driven by the first risk. The current market volatility, however, is more related to the second risk.

The current status of domestic policy, combined with the actions of foreign policymakers, likely blunts the tools domestic policymakers have to address disinflation/deflation prospectively. In addition, given the extremely low levels of Treasury yields, it is quite difficult for investors to find any investment that will suitably hedge against the risk of a disinflation/deflation scenario. So both policymakers and investors are in a bind. I will elaborate a bit more on this point later.

Since I focus all of my attention on the bond markets, I am always on the lookout for changes in fixed income market prices, which may indicate the ever shifting views of market participants with respect to those two risks.

The key metrics I watch are the changes in real yields observed in the Treasury Inflation-Protected Securities (TIPS) market and changes in inflation expectations implied from the yields on nominal Treasury notes and TIPS real yields. Lastly, I study the prices of inflation options to assess the relative risk premium for protection against deflation compared to protection against inflation. I would hope that the folks at the Fed are looking at the same indicators.

The most significant moves over the last month have occurred in the pricing of inflation expectations. There have been significant declines in not only short-term inflation expectations, but more importantly, in longer-term inflation expectations. While short-term inflation expectations can be volatile since temporary factors may influence near-term inflation, the impact of those temporary factors should be muted in longer-term inflation expectations. So the large declines in long-term inflation expectations are certainly ominous and they should serve as a major concern.

While longer-term inflation expectations have declined significantly, somewhat surprisingly, long-term real yields have not declined all that much. Ordinarily, real yields decline as inflation expectations decline, since the market expects monetary policy to respond to inflation declines by easing policy — by cutting rates or, more recently, by buying more bonds in the program known as quantitative easing.

The main objective of easy monetary policy is to lower the real yield, and if possible, bring it to negative levels. The only way to achieve negative real yields is by bringing down nominal rates quickly while inflation remains positive. Once inflation starts to turn negative it will be impossible to achieve negative real yields even with nominal yields at zero. Instead, as inflation turns more negative, the real yield grows more positive. It is this dilemma that results in the so-called liquidity trap. So as long as inflation stays positive, the objective of policy is to keep nominal rates below the level of inflation to produce negative real yields. By sustaining negative real yields, the hurdle rate for businesses to undertake new capital projects is lowered, expanding business activity and the demand for labor — at least that is the theory!

The observation of lower inflation expectations, without a major decline in real yields, suggests, to me, that the market is not convinced that the Fed will restart its bond buying program in response to declines in long-term inflation below its 2 percent target. My concern is that even if the Fed did restart bond buying, it would not be very effective for reasons I outline below.

Additionally, over the past month, there have been shifts in the pricing of inflation options, which suggests greater demand for deflation protection relative to inflation protection. However, this pricing is nowhere near the levels witnessed in 2009 when the demand for deflation protection was close to its peak.

So, in my opinion, the current market volatility stems from the ever-shifting market sentiment regarding a disinflationary scenario with either a muted monetary policy response or an ineffective one. And given the severity of such a scenario, small changes in its likelihood can move the market — a lot.

The Federal Reserve’s decision to cut rates to zero and buy bonds in the wake of the financial crisis enjoyed numerous advantages at the time that it may not enjoy in the future. Despite economic weakness in Europe at the time, the European Central Bank resisted its own version of QE, giving greater economic reward to the Fed’s policies since they were not diluted by the effects of a comparable global policy.

The rewards to monetary policy are much greater when they are asymmetric with global policy, primarily through the impact on exchange rates. If all central bankers adopted QE at the same time, there would be limited movement in currencies and the stimulatory benefits of QE would be limited to its impact on real yields as the primary driver to stimulate domestic activity. But when QE also results in currency weakening, export demand grows and import demand weakens, providing enhanced benefits to domestic growth and employment beyond the real yield effect.

Additionally, when the Fed first embarked on its quantitative easing program, it had a much smaller balance sheet and owned a substantially smaller proportion of the outstanding Treasury bond market compared to today. So it is unlikely that the Fed has the same capacity for bond purchases today without significantly damaging Treasury market liquidity. Therefore, I believe that the ability of the Fed to address a deflationary scenario prospectively is much more impaired.

I like to analogize this situation to the development of antibiotic resistance from overuse of antibiotics. Physicians recognize the importance of preserving the most powerful antibiotics for the fight against those bacteria that have developed resistance to more commonly used antibiotics. Unfortunately, the Fed has used its most powerful economic antibiotic for an extended period of time, and I suspect the economy has developed resistance to this therapy.

So unless the Fed has cooked up a new economic therapy in its research labs to respond to the next bout of deflation, there may be more significant economic morbidity and mortality on the horizon.

Paul Solman explored the impact of the Fed’s monetary stimulus on the economy last December, when the Fed first decided to taper.

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