Tuesday, December 22, 2009

Explaining The Seemingly Puzzling Market Patterns

Apparent puzzle Nr.1 : U.S. Treasury yields are rising-yet the U.S. dollar is rallying. If there was an increase in demand for U.S. assets you'd expect yields to fall-and if there was a decrease in demand you'd expect the dollar to fall.

Apparent puzzle Nr. 2: Gold has been dropping in value suggesting decreased fear of inflation-yet the yield spreads between regular Treasury securities and inflation protected securities (TIPS) have increased (And since I wrote about it last week, the spreads have increased further), suggesting increased fear of inflation.

Some, like Robert Wenzel, have tried to explain the first apparent puzzle, as well as the drop in gold, with tight monetary conditions. But that is not consistent with a rallying stock market and the drop in real Treasury yields (as measured by TIPS). So while this factor is probably behind a limited part of market movements, it is not sufficient to explain the all the current market movements.

Is there an explanation that is consistent with all of the facts? Yes, there is, namely that market expectations of a stronger economy and higher inflation have increased, something which also increases expectations of the Fed tightening monetary policy.
Expectations of a stronger economy would explain why the stock market is rallying even while bond yields are rising. Higher yields also mean that demand for dollars are rising, causing its exchange rate to appreciate. And while higher expected future inflation is positive for gold, higher interest rates is negative for gold as the opportunity cost of holding gold rises. Furthermore, a stronger dollar is bearish for the U.S. dollar price of gold.

Note of course that expectations of a stronger economy and higher inflation doesn't necessarily mean that it is certain or even likely to happen (And I for one remain skeptical to say the least about the robustness and sustainability of the recovery), anymore than expectations of constant annual double digit increases in house prices a few years ago or the expectations a decade ago that most tech companies will grow as big as Microsoft turned out to be true. However, the thing that matters for current market movements isn't whether or not these expectations are rational or realistic, but on whether market participants act on them. And they are acting on them.