1. The Fed funds rate
Fed funds futures markets suggest that official US interest rates will start to rise in the autumn, having been stuck at rock-bottom levels for over a year. Futures markets suggest the Fed funds rate at 1 per cent by next April; it is now 0.17 per cent.
In theory, such rises shouldn't trouble stock or bond markets; investors will price them in months before the event. History, though, suggests things are not so clear. The precedent for this is 1994, when the Fed began to return interest rates to normal levels after an extended period at very low levels following the Savings & Loan crisis and the early 1990s recession. Everyone knew these rises were coming, but stock and bond markets were clobbered anyway.
2. Core inflation
There is no hint of a problem in the short term; headline inflation both here and in the US is benign. But the measure that matters most here is the US's personal consumption expenditure deflator excluding food and energy. Inflation on this measure is now 1.4 per cent, which is in the upper part of the Fed's forecast range for year-end, which is 0.9-2 per cent.
Ordinarily, we'd expect inflation to fall simply because unemployment is still so high. Traditionally, unemployment has been a great leading indicator of inflation because when there's lots of spare capacity in the economy, companies hold prices down to try to win new customers.
However, the banking crisis might have changed things. Some firms are unable to raise working capital from banks, and are therefore unable to expand even if they wanted to. Such firms have no incentive to cut prices to win new customers. If there are enough credit-constrained firms, inflation might not fall as much as past relationships would predict.
This in turn gives us a reason why a rise in the funds rate might be bad for equities. If inflation does rise, it would be a sign that the financial crisis has indeed done lasting damage to the economy, as it has reduced its trend growth rate - the rate at which it can grow without generating inflation. And lower trend growth would be terrible for equities, as it means lower future earnings growth.
3. Lack of credible government
All the attention is focused on cutting the deficit. Mathematically, this can only happen if private savings fall or investment rises, and the government has little control over either of these. What it needs to produce is not a deficit reduction plan, but a confidence maintenance plan that will keep bond market investors and ratings agencies onside. Markets need to know that government wants to cut the deficit, not that it's going to.
4. Economic disappointments
The consensus is that the UK will continue to pull out of recession. Forecasters polled by the Treasury expect GDP growth of around 1.3 per cent this year. But there are lots of obstacles to recovery: spare capacity will hold back capital spending; banks remain loath to lend and firms and consumers seem reluctant to borrow; sterling’s weakness has done little to boost net export volumes; and post-election public spending cuts will dampen aggregate demand. The Bank of England will respond to these problems by keeping Bank Rate low. It's quite possible that it stays at 0.5 per cent until next year, and it's even possible that the Bank will resume some form of quantitative easing if we do get unpleasant surprises about economic activity.
5. Overexuberance
One of the myths of the credit crunch and the subsequent downturn is that all the money created via quantitative easing programmes has poured into asset markets, creating price bubbles. In the UK at least, there is surprisingly little evidence to back this up. However, foreigners have been buying US equities in substantial amounts – $34.1bn (£22.8bn) in the last three months, according to the US Treasury. Such buying has in recent years been a lead indicator of poor returns.
6. Something else
What else? We don't know. That's the point. The trigger for the financial crisis was just such an unknowable thing – the decision to allow Lehmans to fail. It's precisely such unforeseeable events that move markets most. Statistically, the annualised volatility of weekly moves in 10-year gilt yields since 1988 has been almost one percentage point. This implies that there's a one-in-six chance of yields rising above 4.9 per cent by the year-end, or of them dropping below 3.2 per cent.
