Rollercoaster ride for global markets

So it's been a while since the last update, and The Economist captures it best: "it's rough out there."

The Fed cut interest rates 75bp last Tuesday in a surprise effort to stabilize US and global financial markets. This was in response to a broad sell-off in European and Asian markets last Monday, and was the first "intervention" between Fed meetings since September 11th. The 75bp cut was also the largest in a quarter century.

But while Bernanke is looking to calm markets that are reacting violently to the possibility of a major US recession, John Authers of FT.com notes that, in the coming weeks, better news about the economy could, paradoxically, "induce much more turmoil" in world markets. And so it seems that the rollercoaster ride might continue for US investors...

The Short View
By John Authers
Published: January 25 2008 02:00 | Last updated: January 25 2008 02:00
What would really throw a wrench into world markets? Remarkably, news that Société Générale, one of the biggest banks in Europe, had suffered a €5bn trading loss from the actions of a rogue trader was greeted as good news. European stocks rallied and US stocks stabilised (by recent standards).

Traders seemed reassured the huge sell-off earlier this week might have an explanation - even if it carried the disquieting implication that the Federal Reserve did not need to make its intervention on Tuesday.

No, what would really throw markets for a loop would be if the US could avoid a recession. And it now occurs to some traders that that might happen.

Initial jobless claims yesterday fell for the fourth week in a row. US employment data are notoriously unreliable but, if there is a wave of firings going on, it is well hidden.

Claims grew by two-thirds over a year as the last recession took hold - no such trend is at work now.

The jobless claims data prompted some analysts to revise their expectations for this month's non-farm payrolls, due next Friday - two days after a meeting of the Fed governors.

The chance of more extreme volatility - and possibly a true "bear market rally" - if jobless numbers are much better than expected is very high.

The market is retreating a little from its view that a cut of 50 basis points in the Fed funds rate is a certainty next week, largely because of this data. But if the US does avoid a recession, the implications go further.

Two-year Treasury yields have dipped from 5 per cent to 2 per cent in barely six months. If the economy survives unscathed, there is potential for grievous losses in that market. And, of course, world equities would have to unwind many trades of the past three weeks.

So good economic news from the US could yet induce much more turmoil than the actions of an irresponsible trader in Paris.

www.ft.com/shortview

Copyright The Financial Times Limited 2008

Market Update

The major indexes moved sharply lower Friday morning. The Dow dropped below 13000 for the first time in a long time. As it stands now, the S&P is only up about 2% from the start of 2007. What is going on? It seems that fears that we may be headed towards recession, or are already in one, are getting priced into the equity markets, echoing the sentiment of the debt market. Jobs data came in, and showed that the economy had added the fewest number of jobs since August 2003, when the economy recovering from a recession. Yesterday, data came in which showed that the manufacturing sector, which had been holding strong, was weakening considerably. Car manufacturers, for example, reported a 3% drop in sales of cars and light trucks in December. All told, not a pretty picture for the real economy. Investors seem to be abandoning the hope that the turmoil would be limited to the financial markets.

While many expect a rate cut from the Fed at their next meeting at the end of the month, they may not be able to cut rates as far as they did in 2001. Surging commodities prices, caused in part by increasing demand from the developing world, turmoil in resource rich countries, and the increasing use of corn to make ethanol, have created significant inflationary pressure, as higher input prices trickle down throughout the economy.

But all is not lost. It is still possible that economies in the developing world, and to a lesser extent in Europe, will remain robust and help limit the downside to the US economy, and to American investors. The risk is that the theory of "decoupling," which asserts that financial markets are no longer tied to each other as strongly as they once were, does not pan out, and that weakness in America will spread to the rest of the world.

It will be fun to watch from the sidelines.