2 Reasons Markets Are Even More Unstable Than We Thought

What You Need to Know

Investors have adjusted to global tensions, slowing growth and Fed tightening.
Rapidly declining trust in the Fed and a push for sweeping tax cuts in the U.K. have been politically and economically destabilizing.

Frequent flyers are accustomed to turbulence on some flights. Indeed, many expect it. Despite such anticipation, however, the turbulence can once in a while create significant anxiety among even the most seasoned travelers.

This is what happened in markets last week. The “expected” turbulence, related in large part to three continuing paradigm shifts, was turbocharged by two less-anticipated factors, whose duration will play an important role in determining the orderly functioning of markets.

Most economists, investors and traders have by now largely internalized that the global economy and financial markets are navigating three regime changes:

Predictable injections of central bank liquidity and floored interest rates have been replaced by a generalized global tightening of monetary policy.
Economic growth is slowing significantly as the three most systemically important regions of the global economy lose momentum at the same time.
The nature of globalization is shifting from the presumption of ever closer economic and financial integration to greater fragmentation in part because of persistent geopolitical tensions.

Both by themselves and collectively, these three changes involve increased economic and financial volatility. In terms of the distribution of possible economic and financial outcomes, the baseline is becoming less attractive and more uncertain, and the possibility of highly negative scenarios become greater.

Last week’s market developments, including the eye-popping price moves in fixed income and foreign exchange, went beyond investors and traders having to deal with these three inconvenient paradigm shifts. Two additional factors made the week particularly unsettling.

The first was the accelerated loss of trust in policymaking. Markets, which for years appreciated the US Federal Reserve and the UK government as volatility suppressors, have shifted into viewing them as significant sources of unsettling instability.

After being seduced by the notion of “transitory” inflation and falling asleep at the policy wheel, the Fed is playing massive catch-up to counter high and damaging inflation. But having fallen so far behind, it is now forced to aggressively raise rates into a slowing domestic and global economy. With that, the once wide-open window for a soft landing has been replaced by the uncomfortably high probability of the central bank tipping the US into a recession, with the resulting damage extending well beyond the domestic economy.