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The weakness in the Chinese stock market - the focus of last week's column - continued this week, with a sharp sell-off on Monday. But the sell-off in New York on Tuesday and Wednesday was not directly related to the events in Shanghai. Indeed, even Hong Kong refused to let Shanghai drag it down. This time, the bad news spread from west to east instead of the other way around.
So what gives? Unfortunately, lots of things are giving way. One is the pretence that the American housing market is going to emerge from its funk any time soon. The almost pathetic efforts of real estate players such as the National Association of Realtors, to persuade people - or perhaps itself - that the worst is over and recovery is imminent, have simply been drowned by the grim reality of the market. The result is that the NAR has steadily reduced its projections for median house prices in 2007 from a small rise (in its March analysis) to a steadily larger drop (0.7% in April, 1% in May and 1.3% in June). The scale of the projected fall may seem marginal, but house prices have never recorded an annual drop in the 40-year history of this group, and the trend reflected in this relentless retreat tells its own depressing story.
The other thing that has crumbled in recent weeks is bond prices. The yield on the 10-year US government bond is now almost back to 5%, compared to around 4.6% only a few weeks ago and the highest rate since last August. One analyst went so far as to say that if the 10-year bond yield rises above 5% "the 20-year bull market in bonds is over."
Ironically, the developments in the bond market have been feeding off a string of positive data releases regarding the current state of the US economy. Although first quarter growth was the lowest in five years, having been revised down to an annual rate of only 0.6%, data for April and May have been healthier - at least in some respects. Surveys of both manufacturers and service sector companies have been strongly positive, for example, as have factory orders and some other data regarded as forward-looking.
But the bond market has probably been more worried about signs of inflationary pressures, especially via labor costs, than it has been excited about the prospects of strong economic growth in the face of severe headwinds from the direction of housing. There is also the nagging worry of energy and food prices, the rise in which not only creates inflation at the consumer level but also erodes the amount of money left for households to spend on things other things.
Nevertheless, as noted, the bond market has been trending lower for some time. Perhaps the critical development in recent days, and the thing behind the change of direction in the share market this week, has been the change in perceptions regarding prospects for short-term interest rates. The economic data and the way the Federal Reserve has reacted to them have convinced the markets that their belief that the Fed will soon start cutting short-term interest rates is mistaken. The previously unthinkable idea that the Fed's next move may be to raise rates further is now gaining credence. With no prospect of lower rates at the short-end and with rates rising for bonds with redemptions of two years and upwards, the world suddenly looks a very different and glummer place.
Equity analysts have sought to resist the implications of this change by arguing that share prices are determined by expectations of future earnings of the company in question - and earnings are still rising. But this is only part of the equation, because future earnings have to be "discounted" to present values and this is done by using interest rates. The higher the interest rate the greater the discount factor and the lower the value of future earnings - and hence of the company and its share price. That's why major moves in the bond market must impact the equity market sooner or later, and it looks like that time has arrived.