This Market Correction Will Pass

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 |  Includes: DIA, QQQ, SPY
by: Calafia Beach Pundit

Markets appear to have overreacted to hints that the Fed would taper its QE3 bond purchases sooner than expected. We are still months away from any actual tapering, and at least a year or two away from any meaningful Fed tightening that might threaten the recovery. In the meantime, sensitive and timely indicators show no sign of any deterioration in the economy, and that suggests that risk asset prices are likely to recover.

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Seasonally adjusted claims, shown in the chart above, are continuing to decline, down almost 9% from a year ago. On a non-seasonally adjusted basis, the actual number of new claims for unemployment last week fell to its lowest post-recession level, 293K, down almost 10% from a year earlier. No sign here of any deterioration in the labor market, and that in turn strongly suggests that the economy is still growing.

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Over the past year, the number of people receiving unemployment compensation has dropped by over 1 million, or about 19%. Since the peak in early 2010, the number has declined by 6.9 million. On the margin, about 750,000 people have dropped off the unemployment rolls in just the past three months. These are very significant changes that increase the likelihood that the economy will continue to expand, because a substantial number of people have an increased incentive to find and accept a new job.

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Announced corporate layoffs have been low and relatively stable for almost two years. Businesses are not tightening their belts, and that's another good sign that the economy is still growing.

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Two-year swap spreads are excellent leading indicators of the health of financial markets and the economy. They remain unusually low, which means markets are very liquid and systemic risk is very low. They show absolutely no sign of any distress that might lead to an economic slowdown.

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Credit default swap spreads have jumped in the past few weeks, in line with the correction in equities (and particularly those that are sensitive to rising interest rates), but the magnitude of the jump is not nearly big enough to signal a big problem. The level of spreads continues to reflect a market that is cautious and skeptical, but the increase in spreads on the margin is almost insignificant from an historical perspective.

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Similarly, the increase in broader measures of credit spreads in recent weeks is almost imperceptible. Recent developments in credit markets reflect caution, not deterioration.

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The above chart of five-year real yields on TIPS shows the market's most dramatic reaction to the hints of Fed tapering. Real yields have jumped significantly all across the TIPS curve. But they are no higher today that they were at the beginning of last year. What stands out here is not the recent rise in real yields, but the degree to which real yields had fallen earlier this year. That was a clear sign that the market was worried that the prospects for economic growth were dismal. Real yields now reflect much less concern about the health of the economy going forward. Real yields are still orders of magnitude lower than they would be if monetary policy were tight enough to threaten a recession.

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As the chart above shows, the rise in real yields is also telling us that inflation expectations have dropped. But expected inflation is still in line with the norms of the past, and there is no sign here of any deflationary threat that we might expect to see if the Fed were indeed expected to become so tight as to threaten the recovery.

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The VIX index (an excellent proxy for the the market's fear and uncertainty) has jumped of late, but from an historical perspective this is only a minor tremor.