First, Bush administration officials puzzled over Americans' pessimism in the face of strong economi...
First, Bush administration officials puzzled over Americans' pessimism in the face of strong economic performance. Now the financial markets, which limped into the New Year, seem to be giving the president the same treatment.
In economic terms, 2005 was about as good as it gets. US gross domestic product growth will probably come in between 3.5% to 4%. Job creation has been quite high and the economy has weathered hurricanes and high energy prices as well.
But how have the markets responded to all that good news? At least lately, long-term interest rates have headed south and equity markets have gone along with them.
Long rates have dipped so low, falling below short-term rates to produce the phenomenon known as an inverted yield curve, they might even be signaling a coming recession.
There are certainly economic stresses and strains. Higher interest rates may cause housing prices to tumble, bringing consumer spending along with it.
The US has troubling twin deficits that may put upward pressure on interest rates, magnifying that downdraft.
The problem is, the US is carrying so much momentum into the New Year, it seems unlikely that these alone could push the economy into the kind of negative territory envisioned by the bond market.
Indeed, corporate balance sheets are about as solid as they have been in memory, with debt loads relatively low and cash abundant. Higher interest rates should be a minor annoyance at best.
So, if the economic data are not driving the bond market, what is? A brilliant new paper by Harvard economist Robert Barro may shed light on recent events. Barro set out to evaluate the extent to which low-probability disasters have a significant impact on markets.
Economists have wondered, for example, why real returns on bonds have been so low relative to equities over recorded US economic history. Interest rates have often been lower than economic theory predicts they should be, while equity returns have been higher.
Using data on rare negative events such as wars, Barro shows that economic models incorporating these rare events do a remarkable job matching the data.
If Barro is right, long-term rates may depend on low-probability geopolitical variables and the effects may be enormous, perhaps even dwarfing the effects of traditional variables such as the deficit.
Barro clarified this connection in a recent interview: "A small increase in this kind of risk, as an example, due to the 11 September events, leads to a noticeable response in real interest rates.
"When this probability goes up, the risk-free rate goes down because people put more of a premium on holding a relatively safe asset."
Given Barro's findings, one cannot avoid the possibility that long interest rates have been moving down because of the flight to safety associated with heightened geopolitical risk.
Of course, the problem may not be that markets are worried about the actions of Israel and the US.
A bellicose and unpredictable Iran, potentially armed with nuclear weapons, could thrust the world down the kind of disastrous path studied by Barro.
It might well be the case that the reality of a near-nuclear Iran is beginning to cause financial markets indigestion.
Iran, not Iraq, may be the big story of 2006, both politically and economically.
If the economy is doing fine, but geopolitical risk is driving financial markets, then the economic outlook for 2006 may, perhaps paradoxically, have significantly more upside potential than many believe.
Firstly, the downside scenario is so terrible that diplomacy might well lead to a defusing of tensions on the nuclear issue.
Barro has argued that small movements in these probabilities can be a big deal for financial markets.
Secondly, if nothing happens, we may experience an unusual confluence of economic events. Normally, when the economy has loads of momentum, long-term interest rates fly up, which then slows growth.
A flight to safety because of uncertainties over Iran may mute that effect, allowing growth to be higher than it otherwise would be.
But even if GDP soars, financial markets may continue behaving in ways that defy the economic data unless stable and democratic governments take root in the Middle East.
Inverted yield curve in the US.
Geopolitical variables have big impact on bond prices.
Iran is a big threat to US Treasuries.
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