Ukraine/Russia: the panic mood has dissipated

Outlook:

Friday’s development were a one-time panic driven by a headline. After months of refusing to respond to Ukraine/Russia, traders in various markets suddenly decided to have a fit of the vapors. And just as suddenly, the panic mood has dissipated. This goes to show that we know all too little about how panic becomes contagious. This time it’s not contagious, and possibly we could have/should have known it would not be from previous behavior… but you never know.

It doesn’t help that the rising US yields we “should” be getting is simply not materializing. This lays a floor of uncertainty under everything, like the deck of a ship rocking to and fro in a storm. There are probably a dozen reasons for the yield to be falling since year-end 2013. See the chart. But nobody knows which of the dozen reasons is the critical one.

One of the consequences of a fear-ridden markets is a return of the oft-touted correlations among asset classes. These tend to fade away under normal conditions and re-emerge under crisis conditions. “Oil is higher because the dollar is lower” is our favorite case of circular reasoning, always paired with “the dollar is lower because oil is higher.” We have yet to see much of this effect because panic seems to have dissipated over the weekend, but let’s not forget that this is a side-effect and must be expected next time. The only lasting effect of the one-day panic seems to be the lower dollar index, which tried for a recovery overnight but is fading again. It’s hard not to imagine a continuation of the pullback now that it has begun.

Not helping the dollar are events in Ferguson, Missouri, capturing headlines around the world. This looks like Belfast in the 1970’s, not America in the 21st century. We have militarized police, understand-able enough when terrorists could be anywhere and the Pentagon has so much surplus stuff to sell, but everyone notices that it’s ridiculous for cops to be wearing jungle and desert fatigues in Missouri, not to mention using flash-bangs and tear-gas, pointing guns at bystanders, and arresting reporters. It is 44 years since the Ohio National Guard fired on students at Kent State. It’s hard to accept the US as a world leader when Congress plays with sovereign default and police shoot teenagers. Does disdain for the US (also too fat, too smug, and too vulgar) harm sentiment toward US assets? Yes, although no one can say how much.

The immediate bit of data on the horizon is US consumer prices tomorrow, expected at 2% from 2.1% in June, according to the Bloomberg survey. In short, nothing here. Also this week we get July housing starts, new and existing home sales and the Philly Fed.

On Wednesday we get the minutes of the July 29-30 FOMC, and on Thursday, the Jackson Hole sympo-sium begins. (Also Thursday is the HSBC flash manufacturing PMI for China.) The Jackson Hole topic is labor market dynamics. The feeling is that Fed chief Yellen will not use Jackson Hole as a venue to mention, let alone announce, a policy shift. She speaks at 10 am ET Friday and Draghi speaks at 2:30 pm ET.

To a certain extent, we have a battle of the two Anglo-Saxon central banks. Carney said “The easy bit of the expansion has happened. Now we are coming to the tougher part where you ultimately have to see productivity pick up, real wages pick up, sustainable consumption and export competitiveness return.

That’s what we are providing guidance for now.” In other words, Carney is not waiting for wage growth to appear. He believes economic models that say it “should” appear and wants to make policy for what should happen, not relying on lagging data. As one analyst put it, you throw the ball where the catcher will be, not where he’s standing now. Analysts are starting to expect more MPC votes for a rate hike. This tends to roil sterling.

The Fed, meanwhile, is universally thought to be “behind the curve” and willing to keep rates lower for longer until it can see the whites of inflation’s eyes. The FOMC has its own divisions between doves and hawks, but it’s Yellen’s view that counts. Not getting enough notice is Yellen (and Stanley Fisher) won-dering about financial stability issues. This goes far beyond the possibility of another taper tantrum. We know there are bears in the woods, but are they lurking behind the next tree?

If a bear is lurking behind a tree, it may be a panda. Periodically markets get upset about a hard landing in China, and despite reassuring (if not always credible) data, we may be due for another bout of doubt. The FT notes that among the data recently released, a report today shows non-financial foreign direct investment in China dropped 17% to $7.8 billion in July. Even if we believe stimulus is going to come at any minute, China has a mountainous backlog of unproductive investments to work off, in real estate but also in heavy industry and banking. Fear of a hard landing could come back.

The only lasting outcome of Friday’s panic attack seems to be to trash the dollar. Since we don’t expect a rise in yields to be lasting, anti-dollar sentiment may stick. But at the same time, pro-euro sentiment is not strong enough to give us a proper reversal. We would have to see 100-200 points for that. That means the focus can turn to other currencies, like the CAD and AUD, and including the crosses, where attention always goes when we don’t have a clue about EUR/USD. This week might be a good one to retreat from opinionated positions.