A sentiment driven game of ping pong...

Markets of late are in a sort of tug of war frenzy, undecided on whether it is the deflationary forces of a worsening housing slump combined with a steadily deteriorating credit market or the inflationary forces of commodity prices that show no end in sight that will drag the world economy into a recession. Complicating matters is the geopolitical risk premium on oil which has been the dominant factor behind the recent volatility in prices. With so much uncertainty out there, it is no wonder that markets are trading on nothing else than emotional impulses, observable from the steady rise in volatility over the last couple of months. For rational behavior to return would first and foremost require a fix of the housing market which, unfortunately, is in such a dismal state that it wouldn’t be realistic to expect a recovery any time soon. It would also require an improvement in the financial sector that has been battered by several waves of mortgage related write-offs and a systemic risk potential resulting from the broad market exposure to derivative instruments such as credit default swaps that are suffering from uncertainty in counterparty risk. The Fed's Bear Sterns intervention back in March was designed to avert the very systemic risk that continues to threaten the global economy. Unfortunately these problems are likely to persist as long as home values continue to deflate and credit becomes increasingly difficult to obtain.