Strategic Currency Briefing

Outlook

More than one analyst says that the dip in equities will not turn into a rout in part because central banks are giving away free money and can be expected to continue to do so for the foreseeable future. Oh, dear. The implication is that Yellen and other central bankers will continue to pour cash into the pig trough in order to prevent an adverse stock market reaction to geopolitical events. We say such a self-centered view of the world is just plain wrong. We have no evidence that any central banker makes policy based chiefly on what stock markets might do in response.

Central bankers no doubt cast a weary eye in the direction of equity markets, just as they look at currencies and commodities, but to imagine that Yellen would postpone any policy action to prop up equities is not a well-informed view of the Fed chief or central banks in general. The New Yorker profile of Yellen in the current issue doesn’t even mention equity markets (and covers moral hazard all too sketchily). Yellen’s first, second and third priorities are the labor market and unemployment.

A more instructive way to look at it is proposed by the chief strategist at BlackRock, Mr. Koesterich, in the FT today. He says “it’s too quiet” and the lack of response in equity markets to geopolitical turmoil does get put in the central bank column. Abnormally low volatility is function of insufficient fear of volatility. “Financial market volatility is mostly driven by the credit cycle. When monetary conditions are loose – meaning credit is both available and cheap – market volatility tends to be lower. This relationship is evident when you compare equity market volatility with a proxy for credit market conditions, such as high yield spreads. In the past, the correlation between high yield spreads and equity market volatility has been roughly 80 per cent.”

“Still, all else being equal, stocks can continue to climb this year. Stocks are fully valued after a strong rally, but the lack of attractive alternatives (bonds are expensive and cash pays zero), and a slow, but steady, recovery, can support further modest gains. That said, further gains are likely to come with more volatility. Complacency is still the biggest risk, with little bad news priced into the markets. Investors might want to consider taking steps that can help insulate them against an increase of volatility if – or when – it spikes up again.”

Again we have the self-centered view of the universe—“What has my portfolio done for me today?” But hidden in the op-ed essay is the key point--that central banking interference—and nobody doubts that QE is interference--distorts the credit market. The credit market is not separate and distinct from other markets—markets together form one organic en-tity. It’s not as if one part of the body can wither away without affecting any other part. In fact, to take the metaphor fur-ther, you can get some weird and unexpected relationships, like gum disease migrating to the heart and literally causing heart attacks.

UK economists George Cooper, who wrote the splendid The Origin of Financial Crises, takes this point of view in Mon-ey, Blood and Revolution. Economics will not be a real “science” until the economy is perceived coherently, using the scientific method. We have to stop believing in two mutually exclusive things at the same time.

Instead of picking out a few data points in the week’s calendar, we are trying something new—copying Econoday’s calendar. We see CPI and existing home sales (tomorrow) and in the UK, the MPC minutes, retail sales and GDP. Sterling should be fun this week, especially against the euro, where we get flash PMI’s and IFO. We can see a small ray of light favoring the dollar in the current environment, but don’t bet the ranch.