Turning on a Dime

It seems that market sentiment has abruptly turned in the past week or two. In late March the financial markets were abuzz with inflation fears. Now, on the other hand, the business press abouds with stories about a coming economic slowdown (though worrying about stagflation might make more sense). Some examples: “Clouds gather on Wall Street“; “Stocks got what they wished for“; “Is the world economy running out of puff?” and “Global equities slide on growth and earnings fears“. Partly in response, US stock markets fell broadly last week, losing about 3% of their value.

Recent movements in the bond market typify this sudden change in investor sentiment, as the following picture illustrates.

Just a little while ago, bond yields were marching rapidly higher; but over the past couple of weeks they have been falling just as quickly. Have we learned anything new in the past couple of weeks? No, not really. Does April of 2005 mark the first time that many economists have worried about the sustainability of the current economic expansion? No.

I have no good explanation for this seemingly bizarre (dare I say irrational?) behavior. Financial markets do overreact sometimes, and at times they go through unexpectedly large swings as a result of new information that was actually unsurprising, such as the release of the FOMCs minutes last week, or the FOMCs statement in March. I think that such movements are often hard to explain if you believe in the perfect rationality of investors (rational overshooting models notwithstanding).

Should we care? It’s tempting to dismiss this new collection of bearish stories as no more than hype, or the most recent “flavor of the month” in ever-fickle investor sentiment. So I’d like to say no, we don’t need to care. Except for this one inconvenient, insurmountable fact: developments in financial markets, such as interest rates and asset prices, can have strong and lasting effects on the real economy.

Kash