Wednesday's Stock Market Decline

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by: Scott Sumner

Stocks dropped sharply this Wednesday morning.

I don't view this decline in stock prices as being important. In recent years, stocks have often plunged for a few days, and then recovered. I put more weight on the level of stock prices, which is still quite high. Thus, I believe the macro economy is still in very good shape.

But there's also something more interesting going on - bond prices have also been falling (i.e. higher yields):

"It's always hard to judge at what point you hit an inflection point where the correlation between yields and stocks goes into reverse," says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. "One of the markers to when that happens is typically when you move from a deflationary era or at least a deflationary mindset to more of an inflationary mindset."

It's potentially a big deal.

An enduring rupture in positive correlations - yields moving up along with stocks - would signal a break in the weak-growth, low-interest regime seen over much of the past decade. Markets driven by negative tandem moves - yields up, shares down - have tended to be in the grip of inflationary pressure or potential economic over-heating.

David Glasner did a very important study that found stock prices became positively correlated with TIPS spreads (inflation expectations) during the Great Recession, but not before. This may have reflected the fact that market participants thought the US economy would benefit from a more expansionary monetary policy during the period of high unemployment and near-zero interest rates. That assumption was correct in my view. If long-term bond yields and TIPS spreads start becoming negatively correlated with stocks, then presumably excessively tight money is no longer much of a problem.

That doesn't mean money is now too easy. In my view, we are so close to optimal that it's hard to be sure whether policy is appropriate or a tad too expansionary. We'll know better in a few years. But certainly most of the data looks pretty good from a dual mandate perspective.

I'd encourage people not to think in terms of binaries, rather shades of grey. Monetary policy has been gradually moving from much too tight, to slightly too tight, to about right. We don't know precisely where we are on the spectrum, but the trend is clear. It's also clear that current monetary policy is far more appropriate than policy in 2009, or 1979, or 1930.