Happy Trails or Fearthquake 2?

This is dangerous. It is Saturday and the time I usually begin the drafting of Tuesday’s blog post. The financial markets will open and close on Monday before I post my usual dribble. Common sense would argue to let the experts stick their necks out and say stupid things that turn out to be wrong. I could instead write about Donald’s ties or Hillary’s latest pantsuit. But no, I decided to join the fray. Don’t ever say that economists don’t live life on the edge. Please note the dripping sarcasm.

Anyway if you have a television or a cell phone, you know that financial markets did a crazy dance on Friday. The main market indexes closed 2% down and US interest rates rose. I am guessing that in some places gravity pulled things up and sinners read Bibles. It was quite a day.

Those of us who were alive and over the age of seven in 2008 remember a similar decline in the markets. In that case one decline led to another and it wasn’t long before billionaires were removing zeroes from their wealth numbers. So if people are a little crazy this week it is because they have personally seen the fearthquake’s ability to turn everything upsidedown. See last week’s post if you don’t know the word fearthquake.

Many of us are beginning the football season unsure of what to bring to the tailgate. Should we bring expensive bourbon or PBR? Was Friday a false signal? Was Friday an exaggeration? Or was Friday the beginning of hell?

I am guessing that Friday was an exaggeration. Mom, that truck is going to hit us. No it isn’t. Yes it is. No it isn’t. Well, it isn’t really a truck. It’s a toy truck.

In my stupid example the truck is a metaphor for rising interest rates. On Friday we saw what happens when more and more people became surer that a truck is going to hit them. Fed officials said this. The ECB said that. Japan said so and so. All that information helped people become more sure that interest rates are going to rise and stocks plummeted.

I don’t question any of that. But what we collectively are not sure of right now is how big the truck is. A truck is coming but how devastating will be the resulting collision?

One view is held by the naïve mathematicians. Naïve means a strong belief in mean-reverting behavior. Suppose you averaged 180 pounds for most of your life and you get ill and lose 20 pounds. A mean-reverting forecast would have you gaining 20 pounds and going back to your normal weight. If an interest rate had an average of 5% and is now 2%, then a similar approach would believe the interest rate is headed back to 5%.

Mean reverting forecasts make a lot of sense. But notice they are based on an “everything else is the same” assumption. You dropped weight because of illness. When the illness departs you gain back the weight… if everything else is the same – your eating is the same, your exercise is the same, and you still have most of your teeth.

But mean-reverting behavior makes less sense if much has changed. With respect to interest rates, has anything changed? It depends on who you talk to or read. My Republican friends would tell me that Obama has destroyed the US economy. As such capital is worth less, the economy will grow slower, and the trust in bonds has diminished. Furthermore demand, like the final third of a cheap cigar, is harder to draw and is leading to permanently lower inflation. My Democrat friends would point to the negative impacts of income redistribution, globalization, and deplorable Republicans in harming economic growth, demand, and inflation.

If these lovely people are correct, then the usual pressures that would produce a return to a 5% interest rate (from the example above) are missing in action.  That means that the changed economic reality of today and tomorrow does not imply a return to any specific higher interest rate. Surely rates will rise but will they rise by 1%, 2%, 3% or more?

These are some of the questions discussed at our Saturday tailgates. Surely our favorite teams will win by many touchdowns and the deviled eggs will be delightful and make the JD go down ever so nicely. But don’t expect that these questions will be resolved on Monday (yesterday) or today. Get your seat belt on for another good ride. Or maybe they will be resolved and today will return to unicorns and methane-free cows. 

I am guessing that the bucking will go for a while but when the dust is settled we will be back on our slow-growth economy with nervous stock prices and interest rates. Interest rates will rise but ever-so-slowly. 

I’ll end this with the lovely words that Roy used to sing to Dale,

Some trails are happy ones,
Others are blue.

It's the way you ride the trail that counts,
Here's a happy one for you.

Happy trails to you,
Until we meet again.
Happy trails to you,
Keep smiling until then.

Who cares about the clouds when we're together?
Just sing a song, and bring the sunny weather.

Happy trails to you,
Until we meet again.