In fact, the surprise is less the markets nervousness now than their earlier confidence. That optimism was based on two shaky-looking assumptions: first, that economic damage from the summers turmoil was either limited or would be mitigated by further interest-rate cuts from the Fed; and, second, that weakness in Americas economy would, in any case, be countered by strength in the rest of the world.
The credit markets, particularly the most dysfunctional asset-backed parts of them, are still something of a battlefield. The corpses from the summers turmoilthe conduits and structured investment vehicles (SIV) which gathered up mortgage-related assetshave yet to be disposed of. That grim process is beginning, and with it the discovery of what subprime-related assets are actually worth. But dismembering SIVs will take time. And, in a cruel irony, American policymakers cack-handed efforts to ease the pain, by giving an official stamp of approval to the idea of a super-SIV, have only added to investors worries. If Americas Treasury is involved, the logic goes, the SIV mess must be worse than it looks. Not surprisingly, investors feel risk-averse again. The spread between high-yield bonds and safe Treasury bonds is now close to its peak in early September.
Even as investors are reminded that the credit crunch is not yet history, the news on Americas economy is mixed. Thanks largely to booming exports, growth in the third quarter will turn out to have been quite robust. At the same time, the news from the housing market gets ever gloomier. Even though fewer houses are being built, the glut of unsold homes is growing. Tighter credit conditions are sapping already feeble demand. Existing home sales fell 8% in September. With the housing bust accelerating, the jobless rate inching up and oil prices close to record levels, the outlook for consumer spending is gloomy.
And the gloom cannot be magicked away by Americas central bankers, as euphoric investors seemed to think back in September. The next meeting of the Federal Reserves rate-setting committee falls on Halloween, and judging by the price of Fed futures, financial markets expect a treat. As of October 24th, a cut in the federal funds rate was regarded as a certainty. But even if the markets are proved right and the central bankers do bring down the rate by another notch, the immediate economic impact will be modest. The effect of lower interest rates takes months to work through an economyespecially when the housing market is in such a slump. And the risk of inflation could anyway stop the Fed from making aggressive interest-rate cuts.
Much depends on what happens outside America. For the past year or so, slower growth in America has been more than offset by strength elsewhere. Since Americas biggest firms make around half their profits abroad, this strength has helped underpin share prices. But Japan and the euro zonethe most important players, measured at market exchange ratesare looking wobblier. The IMF, which just chopped its growth forecast for the American economy next year by nine-tenths of a percentage point to 1.9%, has also downgraded its figure for Japan (by three-tenths of a point) and the euro zone (by two-fifths of a point). Optimists put their faith in the booming emerging marketsChina, India and the like. China, in particular, could counter American weakness by shifting more towards domestic consumption. But that outcome is not certain. Which is another reason why the markets jitters will last long after the pumpkins have gone.
The Economist Newspaper Limited 2007