The combination of widening credit spreads, deteriorating market internals, plunging commodity prices and collapsing yields on Treasury debt continues to be most consistent with an abrupt slowing in global economic activity. Generally speaking, joint market action like this provides the earliest signal of potential economic strains, followed by the new orders and production components of regional purchasing managers indices and Fed surveys, followed by real sales, followed by real production, followed by real income, followed by new claims for unemployment, and confirmed much later by payroll employment. Stronger conclusions, particularly about the U.S. economy, will require more evidence, but from a global perspective, these pressures are already quite evident.
It’s striking how little economic thought seems to go into talking-head assessments of these developments. The plunge in Treasury yields, for example, is attributed to yield-seeking in response to expectations of European Q-ECB. But if investors still retained speculative yield-seeking preferences, we would observe that uniformly through similar yield-seeking in lower quality credit, as well as risk-seeking in equities without large internal divergences (factors that serve as the central distinction between overvalued markets that continue to advance, and overvalued markets that drop like a rock – see A Most Important Distinction). Instead, the broad retreat – though still early – from speculative assets toward havens considered free of default, essentially signals a shift toward risk aversion. Bad things tend to happen when compressed risk premiums meet increasing risk aversion. As I’ve frequently noted, risk premiums tend to normalize in spikes, so low and expanding risk premiums are the root of abrupt market losses. Continue Reading »