When markets are in turmoil, there are lots of moving parts for investors to track. The drama is clear in equities(https://www.wsj.com/articles/asian-shares-lack-direction-1518051458): the S&P 500 is down more than 10% from its peak,and the VIX stock-volatility index has shot higher. But investors shouldn't ignore less drastic moves elsewhere.
Two things in particular stand out: the U.S. dollar and credit markets. The greenback has gained modestly, with theICE U.S. dollar index up 1.8% from the low reached at the start of February. And credit markets have appeared resilient(https://www.wsj.com/articles/what-markets-are-really-telling-us-about-higher-rates-1517824253) in the face of the stockshock, with the yield spread between U.S. high-yield bonds and Treasurys widening somewhat, but still tighter than formost of 2017.
The good news is that so far, these moves signal that the rapid reversal in stocks isn't a huge problem: globaleconomic fundamentals still appear strong, but stocks were too expensive, particularly after January's steep climb andwith higher government bond yields proving a new headwind. But the dollar and credit markets are important to watchbecause they have the potential to amplify the move in equities, creating a more fundamental problem.
Wider credit spreads would send two signals. One would be that uncertainty about the future has increased, withinvestors demanding a higher premium for lending to companies, which could default on their bonds, than to thegovernment. But wider credit spreads would also mean higher funding costs for companies, perhaps acting as a brake ongrowth and investment. For now, the absolute low level of yields acts as a mitigating factor, but this clearly bearswatching.
The dollar could be more disruptive more quickly. The U.S. currency's decline throughout 2017--with the euro climbingfrom $1.04 to $1.20, and emerging-market currencies (https://www.wsj.com/articles/why-a-stronger-dollar-could-spoil-the-emerging-market-party-1514477292) gaining too--helped to buoy markets around the globe. In particular, a rebound inemerging-market bonds and stocks eased financial conditions for these economies, brightening the global growth outlook.Were the dollar to rise sharply, that could disrupt these trends.
For both the dollar and credit, the Federal Reserve likely holds the key. Faster wage growth, a sizable tax cut and abig increase in government spending create a powerful brew. Bond markets have finally started to accept the Fed istightening policy, but the big question now is whether widely held assumptions that rates will top out at low levels arestill valid. If investors begin to rethink that idea in earnest, then the market ride is only likely to get wilder.
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