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The Market Dogs That Didn’t Bark

Did February’s equity-price reversal mark the end of the bull market, or was it just a temporary correction? In addressing this question, one must look not just at the stock market, but also at oil prices, long-term US interest rates, and currencies.

LONDON – Three months ago, I argued that rising stock markets around the world were a consequence of improving economic conditions, not a sign of “irrational exuberance.” Since that commentary was published, share prices accelerated upward, and some “irrational exuberance” did start to appear, leading to a sharp fall in early February. Although most stock markets are still well above their levels of last November, the question lingers: Did February’s reversal mark the end of the bull market, or was it just a temporary correction?

The strongest evidence, as Sherlock Holmes might have remarked, comes from the dog that didn’t bark. More precisely, it comes from three vehement guard dogs – oil prices, long-term US interest rates, and currencies – that slept peacefully through the commotion on Wall Street.

Why this evidence is so significant becomes clear when we recognize that the main risks to the global economy are now completely different from the “New Normal” of secular stagnation, “low-flation,” recession, and European instability that markets have spent the past decade worrying about. The real threats to global expansion and asset prices now come from accelerating inflation, unsustainably rapid growth, and political mismanagement in the United States.

I noted some reasons for this reversal in my earlier column: the world economy is now firing on all cylinders. Every region is now following the US post-2008 roadmap of aggressive monetary stimulus and bank recapitalization, but with long delays that have ranged from three years in Japan and China to six years in Europe and even longer in large emerging economies such as India, Russia, and Brazil.

The danger of recession or a major slowdown has therefore disappeared in most of the world economy, at least for the next year or two. But economic growth does not eliminate financial risks. On the contrary, some of the biggest stock-market crashes have occurred during periods of rapid growth, usually triggered by accelerating inflation and rising interest rates.

The question now is whether these inflation risks are looming over the horizon. Or is it still too early to worry about overheating, given that inflation in most economies is still at or below 2%, interest rates are still negative in Japan and Europe, and plenty of labor and capital remains underemployed?

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It is in addressing this question that we should note the dogs that didn’t bark. The biggest inflation threat this year comes from rising oil prices. The collapse of oil prices from above $100 a barrel in 2014 into what looked like a stable range with a ceiling around $50 has been a major boon to the world economy. But US oil prices broke through the $50 ceiling last autumn, and by January they seemed to be heading for $70, with many traders forecasting a return to $100.

Sharply higher oil prices, at a time when inflation is already creeping up, would be a disaster for the world economy, forcing central bankers to raise interest rates aggressively and possibly provoking a panicked sell-off of long-term bonds. But, luckily, oil prices did not continue rising as share prices declined. Instead, they fell sharply. If oil prices stabilize near their current level, the most immediate risk to the world economy and the bull market in equities will have been removed.

The US bond market was the second dog that did not bark this month, although it did stir a bit uneasily. Much has been written about the rise of ten-year Treasury yields from around 2.5% in early January to almost 3% today. What is really significant, however, is that the 3% level, which has acted as a ceiling since 2011, has not been breached. If US bond yields rose substantially above 3%, this would certainly raise a question mark about US asset valuations. But this has not happened yet – and, more important, the bond market seems to believe that a sustained breakout above 3% in the foreseeable future is very unlikely.

The bond market’s complacency about US interest rates and inflation may be surprising – and in my view it will turn out to be an expensive mistake at some point – but it is a fact. The proof is that the 30-year US bond yield is still only 3.2% – exactly where it was a year ago and in most of 2015 and 2016. It is almost a full percentage point lower than in 2013 and two full points below the level in 2007. In other words, the bond market believes that the long-term outlook for growth and inflation is more or less the same as it was in the period from 2015 until early last year – and much weaker than it was a decade ago.

This confidence may vanish in the future, if bond investors wake up to the long-term risks of US inflation and fiscal profligacy. When that happens, long-term yields will rise steeply and investors really would have something to worry about. For the moment, however, the behavior of long-term US interest rates implies an almost unshakeable confidence among investors that inflation will never again become a serious threat, despite President Donald Trump’s decision to slash taxes, boost government spending, and abandon deficit limits in a US economy already nearing full employment.

This points our investigation toward the third dog that didn’t bark. Currencies were almost completely unmoved by the stock-market commotion. This quiescence makes sense: If investors are unperturbed by inflationary pressures in the US economy, they can surely be much more confident about the rest of the world. In Europe, Japan, and many emerging markets, cyclical upswings are more recent, inflation is lower, and economic management is sounder than in the US. The implication is obvious: The global expansion and bull market will continue, but leadership will move from America to the more promising economies of Europe, Japan, and the emerging world.;

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