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A moderate case of the jitters

As a follow-on to yesterday's post, here is another way to measure how pessimistic the market is, and how much actual deterioration in the fundamentals there has been. The chart takes the Vix index of implied equity volatility and divides it by the yield on 10-yr Treasuries. The higher the Vix, the higher the degree of market uncertainty and fear; the lower the yield on Treasuries, the weaker the economy is perceived to be. So a higher ratio is bad, and a lower ratio is good.

This ratio has recorded some pretty spectacular spikes over the years, but today's level is only moderately elevated (6.26). This jibes with the other indicators I showed yesterday, with the conclusion being that the market is definitely concerned about the outlook and the fundamentals, but not to any alarming degree. I could say the same thing for Euro 2-yr swap spreads, which at 52 bps are definitely above average, but not by a lot.

In Don Luskin's book "I Am John Galt", the section on Alan Greenspan makes the interesting observation that Greenspan was pursuing a stealth gold standard as Fed Chairman from 1987 through the late 1997. The Fed funds rate fairly closely tracked the price of gold, which is what one would expect to see if indeed the Fed were on a gold standard. During that same period, inflation was fairly low and relatively stable, and there was a noticeable lack of market panics. But after 1997 the Fed started raising the funds rate even as gold and commodities declined. Greenspan apparently switched from his Randian focus on gold and adopted the more popular Phillips Curve vision of inflation. Phillips Curvers were very worried in the late 1990s that the U.S. economy was "overheating" and that too much growth would prove inflationary. The facts proved them and Greenspan wrong, however, since the economy slipped into recession in 2001 (as it usually does when monetary policy becomes too tight) and inflation fell to very low levels. In fact, we came pretty close to experiencing outright deflation in 2002 and 2003. That put the fear of God into Greenspan, since he subsequently decided to pursue an extraordinarily accommodative policy for the next several years, and that contributed to inflate the housing bubble. With monetary policy cut loose from the anchor of gold, is it any wonder that the Vix/10-yr ratio has experienced such extreme volatility in recent years?

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