It’s been a rough couple of weeks for the global economy, and the markets have been torn asunder. On Monday, the VIX – a measure of the implied volatility in the stock market – shot up to its highest level since the depths of the 2008-09 financial crisis, up 50% to 48. Tuesday it dropped 27%, the biggest one-day drop in history. Wednesday? Back up 26%. By Thursday, the Dow Jones Industrial Average had experienced its fourth straight day of 400+ point moves, the most in the Dow’s history. So just how long do we have to wait before the market’s mega-mood swings are finally through?
The truth is, nobody knows. But don’t be surprised if the market mayhem continues for weeks – if not months – to come. Yes, the U.S. economy survived a much-feared credit rating downgrade. And in a move to calm the markets, the Fed extended its promise to keep money cheap for several more years. But those don’t change the fact that the global economy’s flawed structure is beginning to come unhinged. Here are a few of the big-picture reasons why the market jitters may stick around:
Currency wars: This week’s pledge by the Fed to keep interest rates low until mid-2013 prompted a stampede into U.S. Treasuries. The yield on 10-year Treasury bonds dipped below its record low in 2008, which, when accounting for inflation, means bondholders are so desperate for the “safe haven” that they’re now willing to pay the government to hold its debt. That may seem like a good thing, since only weeks ago we were panicking about a flight from the U.S. dollar because of a debt downgrade. But the Fed’s low interest-rate pledge may actually accelerate the market turmoil by cheapening the dollar abroad, which puts countries with volatile currencies in a precarious spot.
The Fed’s dire reading on the economy, coupled with the lower yields on Treasuries, led to a global stampede into other “safe” currencies offering higher returns, notably the Swiss franc and Japanese yen. Their currency prices have soared against the dollar in recent weeks, prompting moves by both countries to weaken their currencies to keep their exports competitive and inflation in check. If more currency interventions ensue, expect more volatile markets as global traders attempt to cope. Even before the Fed’s rate announcement, Callum Henderson, global head of currency research at Standard Chartered in Singapore, warned there would be “more intervention in the future and further acrimony in terms of how the U.S. dollar is doing.” Another round of quantitative easing, which flooded emerging markets with hot money during its last rendition, would surely add fuel to the fire.
Trade imbalances: China’s trade surplus rose 20.4% in July to $31.5 billion, a more than two-year high. U.S. exports, meanwhile, fell for the second month in a row in June, widening the U.S. trade deficit to $53.1 billion. That’s the biggest U.S. shortfall in more than two and a half years and a stark reminder that troublesome trade imbalances – widely blamed for causing the financial crisis – are only getting worse. Of course, countries like China, Japan, and Germany have run large trade surpluses for years, while the U.S. and peripheral Europe have run big deficits. And for many years, that setup worked, since both the consumers and sellers of exports benefited. The U.S. was happy to live beyond its means by over-borrowing and spending, while China had reason to keep U.S. borrowing cheap, since its dollar binges kept its exports competitive. But now that credit downgrades and bailouts abound, markets are warier of yawning deficits. Cash-strapped populations are also peeved at the painful cuts required to close their countries’ budget gaps, and the resulting crimp on growth sets back needed shifts on trade.
For markets to stabilize once and for all, a major rebalancing will have to occur. Mervyn King, governor of the Bank of England, made this point in his latest economic forecast:
One way or another, the losses that were built up in recent years will have to be shared between creditors and debtors; in the world economy between creditors in the east and debtors in the west, and within the euro area between creditors in the north and debtors in the south.
China could lend a helping hand by allowing its currency value to increase faster, something the U.S. and other big industrial countries have been pressing it to do. As for Germany, unless it’s willing to see Europe implode, it will have to pay more of its neighbors’ debts and ensure their economies become more competitive. But the longer the surplus countries drag their feet on chipping in, the greater the fear that the global economy will slide back into recession. Big market swings reflect a tug-of-war between investors about whether that fear will come true.
Declining trust: The Fed’s pledge to keep interest rates low for two years elicited mixed market reactions. The intention, it seems, was to boost investor confidence and prompt moves into riskier assets. But after an initial upward jolt in stocks, investors retreated to safe-haven Treasuries, a sign the Fed’s gesture may be all for naught. Similarly, President Obama’s attempt to soothe markets (by saying the country’s problems were “imminently solvable” after the country’s shocking downgrade) also failed to quell fears; The market still dropped over 600 points that day. Indeed, no matter what policymakers say or do these days, investors seem far less willing to take the bait. As the Financial Times notes:
What the markets have grasped is that leading policymakers’ strategies for handling these huge economic and financial challenges still amounts to no more than muddling through. The recent panic was thus understandable.
The command of European policymakers is even more pathetic, especially considering that they lack the luxury of time. Even though they reached an agreement on reforming the EU’s bailout fund, for example, the changes still require the approval of cranky eurozone governments, and they happen to be on month-long vacations. Meanwhile, the most needed eurozone reform by many accounts – dramatically increasing the size of the bailout fund – still isn’t settled, mainly because of German foot-dragging.
That’s left only one institution – the European Central Bank – capable of easing market jitters by buying up billions more in shaky European government bonds while the whole world waits for reform. But the temporary relief comes with a price: The ECB is now contending with its own credibility concerns and a weakening balance sheet. If global institutions don’t start reclaiming their authority by, say, cooperating through the G20 or enlisting cash-rich companies to help mitigate the crisis, investor skepticism will only grow.