We’ve been sayin’ the commodities runup and the fixation on inflation looked like a rerun of spring 2008: a liquidity-fueled hunt for inflation hedges when the deflationary undertow was stronger. That observation is now looking to be accurate.
But what may prove different this time is the speed of the reversal. With investors acting as if Uncle Ben would ever and always protect their backs, markets moved into the widely discussed “risk on-risk off” trade, a degree of investment synchronization never before seen. All correlations moving to one historically was the sign of a market downdraft, not speculative froth. And as we are seeing, that means the correlation will likely be similarly high in what would normally be a reversal, and that in turn increases the odds that it can amplify quickly into something more serious.
The only way to stem this unhealthy pattern of cross market connection is structural measures, meaning measures to reduce the tight coupling of financial markets which allows developments in one market to propagate quickly to seemingly not so closely related markets. But we are a long way away from seeing the authorities consider, much the less act, to stem the free flow of capital, which has long been depicted as virtuous. The work of Carmen Reinhart and Kenneth Rogoff on financial crises shows the reverse, that high levels of international capital flows are strongly correlated with larger and more severe implosions. But we may have to test the current system to destruction before we can develop the will to fix it.
Commodities plunged the most since 2009, led by oil and silver, and stocks posted the biggest three-day drop since March as selling of energy futures drove down equities. The dollar strengthened and Treasuries jumped.
The Standard & Poor’s GSCI index of 24 commodities sank 6.5 percent at 4:01 p.m. in New York and lost 9.9 percent this week. Oil tumbled 8.6 percent, the most in two years, to $99.80 a barrel. Silver dropped 8 percent, extending the biggest four-day slump since 1983 to 25 percent…..
Selling swept commodities markets as investors sold positions following gains of more than 23 percent in 2011 through April 29 by silver, oil, gasoline, coffee and cotton. The dollar, which slumped 13 percent versus the euro between Jan. 7 and May 2 as the S&P 500 Index rallied 7.2 percent, strengthened against all 16 major counterparts except the yen after European Central Bank President Jean-Claude Trichet signaled he will wait until after June to raise interest rates.
“It’s panic,” said Michael Shaoul, chairman of Marketfield Asset Management, which oversees $1 billion in New York. “You have those super crowded trades. Now you’re in liquidation mode. There’s nothing to do with weak U.S. economic data. It’s not a global financial crisis. It’s a classic liquidation move in a crowded trade.”
It’s premature to call this anything other than a sharp correction. Recall in February 2007 that a plunge in Chinese stock markets produced two weeks of jangled nerves and roiled markets, and May 2010, the first serious dose of Euromarket sovereign debt worries, was no party either, yet the markets appeared to shrug those events off. But the underlying financial system has been patched up with duct tape and baling wire, and the thorniest issues, namely, undercapitalized banks and global imbalances (both China-US and within the Eurozone) remain unaddressed. The “It’s not a global financial crisis” sounds awfully reminiscent of “subprime is contained.” It was until it wasn’t.