Kit Juckes, Research Analyst at Societe Generale, suggests that the big story is the divergence between financial markets and the real (US) economy which is surprising but it’s not unique. Key Quotes “The S&P 500 lost nearly 20% in the summer of 1998, as Russia defaulted and LTCM went out of business. The Fed eased by 25bp three times between September and November. GDP growth was 5.3% in Q3 and 6.7% and rates only went back up in June 1999. In 1987, further back, a 30% fall in equity prices didn’t stop Q4 GDP growth coming in at 6.8%. Markets are assuming that this time, the US economy will weaken. There is widespread talk of a major US slowdown, even of recession, and there is no longer any tightening in US monetary policy this year priced into the Fed Funds futures market. But is the US economy facing a slowdown, or is it just trundling along at the 2% or so rate of growth that we have seen for the last 5 years. And if the latter, how will the Fed react to international weakness? My guess is that the weakness in global markets makes an acceleration in US growth to 3% even less likely than it was, but I don’t see precedents that point to major slowdown. Markets matter, but they are not everything. On the policy front however, the Fed has tended to pay attention to markets, so why would that change now? Delaying the next rate hike is easy and the inflation data – despite the acceleration in headline and core CPI last month – aren’t going to scare the Fed into action. But from where we are now the markets are already pricing so little that I can’t see further downgrades to US rate expectations providing either reason to be bearish of the dollar from here, or to be bullish of high-beta currencies. If wiping out all pricing of rate hikes this year hasn’t helped, what would? Falling global FX reserves and the reverse in Fed policy are often cited as reasons for the woes of markets. I wrote about this in the FX Outlook and indeed, in last Wednesday’s FX Daily after the release of TIC data showing USD 48bn net sales of Treasuries y foreign central banks in December. It seems pretty clear that the reverse of major central banks from bond-buyers to bond-sellers has had less of an impact on treasury yields than many expected and more of an impact on ‘risky assets’ than some expected. And this may only just have begun. If I look at G4 central bank balance sheets combined, (ie, Fed ECB, BOJ, PBoC) they have stopped growing but haven’t fallen back. The only one to fall is the PBoC. Two thoughts to end on. Firstly, the market mood could get a lot worse if global reserve reductions accelerate and secondly, those that hope that the Fed can stop tightening, start easing, and make everything alright again need to borrow a copy of ‘Humpty-Dumpty’ from somewhere.” For more information, read our latest forex news.