Positive fundamentals could overcome Black Swan fears

The equity market is beset by fears, (see this post for an explanation of the above chart) but several important economic variables are in favorable territory. Money is easy, systemic risk is low, and energy prices are falling. Disaster can always strike (e.g., in the form of a Black Swan), but in its absence, the positive fundamentals are likely to carry the day.

The chart above compares the real Federal funds rate (blue line) with the slope of the Treasury yield curve (red line). What it shows is that every recession in the past 50+ years has been preceded by very tight monetary policy. Monetary policy becomes very tight as the real Federal funds rate rises to 4% or more, and the slope of the yield curve becomes flat or negative (i.e., when long-term rates are equal to or lower than short-term rates). In effect, tight money starves the economy of liquidity. Today, however, liquidity is plentiful. Banks are lending-constrained only insofar as they are risk averse—they have enough excess reserves on deposit at the Fed to sustain virtually unlimited lending. Meanwhile, bank lending to small and medium-sized businesses has been growing at double-digit rates so far this year.

Swap spreads are excellent indicators of the health of financial markets and good leading indicators of economic health. Although swap spreads have risen a bit of late, they are firmly within the range of what we would expect to see during periods of "normal" economic conditions (e.g., 20-35 bps). Swap spreads are confirming that liquidity is abundant, systemic risk is low, and the economic fundamentals are healthy. Swap spreads in the Eurozone are also down to "normal" levels, even though the Eurozone economy is distinctly weaker than the U.S. economy. All of this suggests that economic activity both here and in Europe is unlikely to deteriorate and more likely to improve over time.

The chart above compares the real price of crude oil with the real Federal funds rate. What it shows is that expensive crude oil prices and tight monetary policy can squeeze the life out of a recovery (note how the gap between the red and blue lines narrows in advance of recessions). Each of the past recessions has occurred at a time when real crude oil prices rose and monetary policy tightened. One reason the current business cycle expansion has been the weakest on record could be due to the fact that energy prices have been very high. The Fed has in effect attempted to offset expensive energy prices with cheap money, but they can only do so much. Now, cheaper energy prices and easy money may have the effect of strengthening the recovery going forward. At the very least, cheaper energy should serve to limit the downside economic risks.

Within the next few weeks, gasoline prices at the pump are likely to post a 20% decline relative to where they were at the end of June, barely four months ago. That's the message of the chart above, which compares gasoline futures prices (orange line) with the nationwide average of regular gasoline (white line).

The miracle of free markets is that prices adjust to match supply and demand. What we are seeing today is energy prices adjusting downwards in response to increasing energy supplies and weaker demand. Higher options prices (as reflected in a rising VIX index) are serving to match some investors' increasing desire for safety (because owning options limits one's downsize risk) with other investors' willingness to take on more risk. When markets are free to adjust, as they are today, this acts as a shock absorber for the real economy, and that in turn helps mitigate disruptions that arise from unexpected developments.

UPDATE: Today (Oct. 15) markets are succumbing to escalating fears, with a taste of panic. Weakness in the Eurozone and concerns about Ebola seem to be the driving factors.

A longer-term chart for perspective:

Equity markets in long-term perspective: