A Little Early to Worry

August 19, 2020

Watching the many little things that go on in the markets is time consuming but every so often a little nugget comes along that shines a light on potential problems. The macro problems with the economy have been well trod here, but the market has bounded higher, without a care for those issues. That may not continue.

The first thing to note is that the members of the Federal Reserve, at their last meeting on July 28-29 “agreed that the ongoing public health crisis would weigh heavily on economic activity, employment, and inflation in the near term and was posing considerable risks to the economic outlook over the medium term”. Members also worried about risks to the financial system.

That makes complete sense because the money they have thrown at the economy won’t be enough to save it, and all that cash just kicked a very, very large can a short distance down the road.

The current financial system of the USA and indeed much of the world, is dependent on low interest rates. The Federal Reserve maintained their focus on keeping interest rates low (near zero in fact) for the foreseeable future. The problem is that government sometimes lose control when they lose the confidence of investors.

While it is a little early to worry, the last month has seen an unexpected rise in interest rates. At the same time there is rather drastic decline in the US dollar. These are warning signs that there may be stress in the system.

The interest rate rise doesn’t really make sense when the Fed is holding the funds rate at (essentially) zero, but it has jumped anyway.

The US dollar is another issue. It is quite literally tanking. It is a significant move down and the reasons are just as likely to be related to economic risk as to political risk. Moves like that get the attention of investors both buyers and sellers of goods, services and investments.

Now to be clear, most of the world still sees the US dollar as a stable reserve currency. That is partly due to globalization and the transactions of goods in US dollars. Unfortunately the current US administration is working hard to dismantle globalization and their related trade deals. As discussed here earlier in the year, there is a significant effort underway in China and Russia to stop using the US dollar as the currency for transactions in oil (the world’s most traded commodity) and other commodities.

Now in the context of the last 20 years, it isn’t so bad, but it is worth noting that Democratic presidents have generally resulted in a strengthening dollar (improvements in the economy and confidence in the country), while repulican presidents have generally resulted in a weakening dollar (less confidence, but also policy actions to make US goods more appealing to foreign buyers).

Overall, there are a lot of reasons to worry, but so far the market has brushed it all aside and is setting new highs. The parallels with the 1930 bounce in the market before the big collapse are eerie and while the tools available to avoid another collapse are far more robust, the resilience of the population is nowhere near as meaningful.

Perhaps it is a little early to worry, but worrying may prove to be the best move.

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