Just like the financial crisis, this week's market volatility emanated from the credit market. In 2007, the problem was collateralized debt obligations, and the credit default swaps that were supposedly insuring their value. This time, it's rapidly falling bond yields, reflecting both deflation fears and slower future economic growth.
In short, the fastest of the fast money got caught offside in terms of inflation – banking heavily on higher future inflation and economic growth while bond yields header lower and lower, signalling the exact opposite.
The chart below compares the U.S. Federal Reserve five-year inflation index (estimating inflation five years out) with the price of the West Texas Intermediate crude oil benchmark. At the beginning of 2014, the Fed index suggested that five years from now, the inflation rate would be in the 2.7 per cent range, significantly higher than the current 1.5 per cent pace. This index's forecast was dependent on a strengthening U.S. economy that would result in healthy inflation.
SOURCE: Scott Barlow/Bloomberg
Global economic data, however, didn't co-operate. Increasingly dire industrial production results came from Europe and Japan, combining with rising skepticism regarding China's economic outlook. As a result, the Fed's inflation forecast plunged beginning in mid-September. Citigroup research notes that current levels of expected inflation are very similar to 2008 and 2010 when the Fed became sufficiently concerned about the growth outlook to announce its quantitative easing programs.
Initially, equity and commodity investors ignored the deflationary signals but at the start of October, the capitulation process began. The S&P 500 began a 5.4 per cent swoon that hit industry sectors sensitive to the global economy, notably oil, exceptionally hard.
As painful as the correction process was for the average investor, Bloomberg reports that it was far worse for leveraged hedge funds. The rapid unwinding of what one manager termed "commonly held trades" goes a long way to explaining the sharp nature of the market's downward move.
Sanguine market action on Thursday and Friday suggests that volatility has likely abated in the short term. But investors need to pay close attention to U.S. inflation expectations and the bond markets for more signs of economic weakness and another potential market down-draft.
Follow Scott Barlow on Twitter @SBarlow_ROB.