The US stock market took a turn downward on Tuesday, June 4, causing a major correction. It was the first time the Dow Jones Industrial Average had dropped that much since the financial crisis in 2008. What happened? Why did interest rates reach such a low level when the Federal Reserve had been hinting at higher rates?
First, let’s look at the numbers. The Dow has lost 933 points, or 2.4%, since Monday’s closing price of 24,893. The broader S&P 500 index is down 2.1% and the Nasdaq Composite is down 2.6%.
The market correction also reflects investors’ concerns that interest rates have reached a “neutral rate” in which they are neither increasing nor decreasing. When interest rates remain low, the credit market is too free-wheeling. There is a limit to how much risks can be taken by borrowers and creditors without causing an economic crisis. This could change if we hit the unknown “neutral rate” level of about 3%.
The market correction is another manifestation of the Federal Reserve’s credibility problem. Many have been saying for a long time that the Fed needs to raise interest rates sooner and more aggressively than it has because the savings in interest payments would stimulate the economy.
But Fed Chairman Jerome Powell has denied that the Fed is on a predetermined course for normalizing rates. Now that we’ve reached the neutral rate, higher rates could lead to a crash — rather than stimulus.
Why are bond yields falling?
Many people think that the falling bond yields are due to the fact that the US economy is slowing down. Some believe that tax cuts by the Trump administration led to some questionable practices, such as raising the stock market with debt issued to stimulate markets. When lower bond yields increase the cost of financing and reduce the liquidity, they lead to lower bond prices and lower yields.
However, many of the investors in these bonds think differently: They don’t think the US economy is slowing. A better explanation may be that bond yields are dropping because the Fed has become less willing to further lower rates because that will lead to more volatile markets and slower growth. However, that doesn’t mean that the current economy is still robust.
According to UBS, the US stock market has just started to rebound after dropping by 6% at the end of May. According to the company, the market correction was triggered by the sudden drop in oil prices and China’s currency depreciation. The Chinese currency recently weakened to its lowest level since 2010.
I’m not a big fan of the Chinese currency because, according to Quartz, “I doubt that China has any intention of letting its currency value fall. It’s probably more a sign of its growing economic challenges.” Currently, the dollar is strong against the Chinese currency, which discourages the country from further weakening it to maintain its trading strength.
In addition, the US dollar is rising against the Chinese Yuan. That’s great for US corporations which are more profitable in Chinese currency. As a result, the US economy will benefit from the decline in Chinese Yuan, and a general decline in the Chinese economy will be beneficial to US consumers.