What Cyprus and the sequester have in common

Suppose I had told you at the start of the year that these things would be true in late March: That a Eurozone country would be in tense negotiations to force losses on its bank depositors that could spiral in such a way that it leaves the common currency altogether, and that the so-painful-no-one-wants-them U.S. spending cuts would go fully into effect indefinitely.

And suppose I had asked you to predict where some key financial market numbers would be: The stock market, yields in key government bond markets, the measure of expected market volatility known as the Vix.


Cyprus crisis? Markets are not impressed.

I know what my answers would have been. I would have thought the stock market would be off maybe 10 or 20 percent from where it was at the start of the year. I would have thought that U.S. government borrowing costs would have plummeted amid safe-haven effects and that the rates faced by peripheral European countries like Spain and Italy would have skyrocketed. And I certainly would have expected a big spike in the Vix, a sign that investors were unsure of what the future held.

I also, as you’ve probably figured out, would have been completely wrong. The S&P 500 is up 9 percent for the year, U.S. Treasury yields are up, Spanish yields are down, and the Vix is hovering near its lowest levels in six years.

The explanations of what is going on can boil down to two categories. In one set of theories, markets have become more rational. In the other, they have become less.

The case for more rational markets goes like this. Rather than gyrating on the latest headline or murmur of news, markets are looking forward a bit. Yes, the Cypriot bailout deal with its 9.9 percent haircut of large deposits may be a bad precedent with consequences for other nations’ banks. But we have over and over seen that, when pressed to the wall, the European Central Bank and other European authorities will do what it takes to preserve their currency union and their continent’s financial system. Why should this be any different?

Similarly, in the fiscal cliff negotiations in December, markets were not nearly as jumpy as I expected, as investors seemed to see-through the brinksmanship to anticipate what sort of deal would come out on the other side. On the sequester, forecasters had generally already built tighter fiscal policy from the U.S. government into their economic models, and never seemed to believe some of the dire warnings that the White House and defense industry were offering of disruptive impacts from the cuts.

Then there’s the less rational case for the markets’ confidence that things will be OK. Call it crisis fatigue. Markets, writes the Brookings Institution's Douglas Elliott, “appear to have crisis fatigue, producing a complacency that combines a tinge of cynicism about the long-term resolution of anything with a belief that the zone can keep dancing between the bullets, in the short run anyway.” (Elliott himself finds the sense of calm to be mystifying).

A slightly more complex version of this is that the very players who would be inclined to go short Europe—that is, the hedge funds normally inclined to short the euro currency, bonds of countries like Spain and Italy, and the stocks of European banks—have lost their shirts over the last year, and thus lack either the financial capacity or the will to make those bets once again. Even if the actual probability of a new wave of crisis is higher than the markets are currently reflecting, maybe there’s just no one left to make those bets.

And relatedly, it may be that the flood of central bank dollars (and euros, and yen) are burying the signals that markets would normally be sending about the outlook. “Central banks’ massive asset purchases have set up a situation where the markets’ normal signalling mechanisms no longer operate because investors have huge volumes of uncovenanted liquidity, created by the central banks, to commit to long-term assets,” wrote Stephen Lewis of Monument Securities, via the Financial Times’s Alphaville blog.

The optimistic view is that the sense of market calm over both Cyprus and U.S. fiscal hijinks is that this is a sign that the financial crisis is truly over, and we have entered an era where there can be good economic news and bad, but no longer the sense that we are on the edge of an abyss where a global economic collapse is a possibility.

The less optimistic take is that for reasons psychological or practical, the markets aren’t giving us reliable signals as to the odds of what will come next.

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Ezra Klein · March 22, 2013