Collywobbles

Feb 25th 2005
From The Economist Global Agenda

This week, America’s financial markets saw a few ghosts, and shivered

THE markets were looking for an excuse to turn tail, and this week they got more than one. Spooked by fear of inflation, high oil prices and a revolt by Asia’s central banks, bonds, the dollar and shares all headed south, in that order. By the evening of Wednesday February 23rd, some poise had been regained. But the ease with which things went wrong—albeit just a bit—has left many wondering just how robust is the consensus view that all’s for the best in this best of all possible financial worlds.

The problems started last week, when Alan Greenspan, the chairman of the Federal Reserve, professed himself puzzled by the “conundrum” presented by the flattening yield curve: the more he raised short-term rates (six times since June 2004, by 25 basis points on each occasion), the more already-low long-term rates fell. Markets don’t like it when the man who sets interest rates says he doesn’t understand them. The gloom deepened when new figures on February 18th showed that core producer-price inflation was at its highest in six years: could Mr Greenspan be behind the curve on inflation? Bond prices headed smartly down, as investors suspected that the Fed’s chairman might see a solution to both problems in lifting interest rates more smartly up.

The next blow fell on February 21st, when South Korea’s central bank, with most of its $200 billion of foreign reserves in dollars, said it planned to diversify away from the currency. Then, with Europe and America gripped by a cold wave, the price of a barrel of oil for April delivery rose back above $50. The scene was set for a sell-off, and on February 22nd the S&P 500 fell by 1.5%; the dollar lost 1.1% against the euro and the same against the yen; long-dated Treasuries continued to fall in price; oil futures rose still more and so did gold futures. Stockmarkets around the world, mostly in sympathy but with problems of their own, slid too.

The sweepers came in overnight to clear away the mess, and by the end of the week things looked better. South Korea’s central bank made it clear that it did not intend to sell dollar assets, just to buy fewer in future. Like other central banks, it has been quietly taking on fewer bonds from the American Treasury and more from other issuers for some time anyway. A mild increase, of 0.2%, in American core consumer prices (ie, not counting food and energy) in January calmed—perhaps temporarily—the previous week’s fears of renewed inflation. And a second take on last quarter's growth numbers—GDP grew by 3.8% at an annual pace, not 3.1% as first reported—confirmed that America's exports were doing rather better than earlier counts suggested. Share prices climbed part of the way back; the yield on Treasury long bonds dropped again; the dollar strengthened against both the euro and the yen; and oil and gold prices slipped back a bit.

How important was this week’s stumble? On the numbers, not very: this was no 1987-style rout. But there has been so little volatility in share prices in the past two years that any sharp change is unsettling. The VIX (or volatility index, alias the “investor fear gauge”) is a contract on the Chicago Board Options Exchange that tracks the implied volatility underlying the S&P 500. As the chart shows, volatility used to be high, touching 45 in August 2002 and then a lower peak of 34 early in 2003. Since then it has headed downwards. On February 22nd, the index jumped by 17.5%—and still only just cleared 13. Mark Hulbert, a columnist for MarketWatch, an online news service, points out that, if historical levels of volatility prevailed, we should expect the stockmarket to gain or lose 2% once a month or so. This week’s fall, though the largest in 21 months, was nothing to write home about.

Investment analysts have two theories on volatility and market performance, and unfortunately they contradict each other. One lot believes that low volatility suggests share prices will fall, as it means that investors are too complacent. They have been predicting a market meltdown for some time. The other group believes that low volatility suggests rising markets, as well-informed investors are rightly confident. The chart supports the latter: while the VIX has been having a near-death experience, share prices have headed up.

What matters most for share prices—or ought to—are the discounted value of companies’ future earnings and the relative attraction of other investments, both of which reflect the state of America’s and the world’s economy. The reason for this week’s wobble is that America’s two greatest vulnerabilities—its dependence on one set of foreigners to buy its bonds and on another to sell it oil—were exposed side by side. VIX or no VIX, not for the last time.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.