US stock markets weaken as bond yields signal deflation is near

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Index Feb15Increasing volatility in major Western financial markets suggests they are struggling to maintain their momentum.

It is certainly hard to be very optimistic about the outlook for the major Western stock markets this year.  The reason is that investors are still failing to think about political risk.  They continue to believe, as they did a year ago, that nothing else matters as long as central banks continue to hand out large amounts of free cash to support stock markets.

But that was then, and this is now.  And in reality, political risk is rising all around the world.  We are seeing it most obviously in Greece, but it is also becoming a bigger factor in the UK ahead of May’s General Election – where it still seems unlikely that any single party can gain a majority .

Developments in the markets themselves also create cause for concern.  The US market is now close to its record level in terms of Nobel Prizewinner Robert Shiller’s valuation metrics.  And it is already at a record level of margin debt.

The reason is that investors have convinced themselves that the US Federal Reserve, like the European Central Bank, the Bank of Japan and the Bank of England, will never let stock markets fall again, for fear of another 2008 crash.

Thus investors, and the media and commentators who support their needs, spend all their time worrying about when US interest rates might rise, and by how much.  Vast forests have been destroyed to provide the paper on which these learned discussions can take place: vast banks of servers have been built to provide their electronic equivalent.

Yet how much power do central banks really have over the world economy?  Does the ability to raise or lower interest rates really enable them to control the economic tide?  If it did, why are bond markets now so convinced that deflation is on its way in many major economies?

We are also already seeing corporate earnings being badly hit by the collapse of oil prices and the surge in the US dollar.  And I remain convinced, as I have argued since August, that these developments are only the first stages of the Great Unwinding of central bank stimulus policy.

Last month, as the chart of the IeC Boom/Gloom Index above shows, the S&P 500 (red line) lost ground for a second month, causing US investment magazine Barron’s to comment:

Stocks suffered their second straight monthly decline, while government bonds soared as their yields fell to record lows.  April may be the cruelest month to the poet, but U.S. equity investors are down some $1.1tn since the market’s peak on Dec. 29. That includes a loss of $600bn last week and $300bn Friday alone, as the equity market failed to get the typical end-of-month lift from big players’ trying to burnish their monthly results.”

And at the same time, the Index itself (blue column) is sliding slowly but surely into serious downturn territory.

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