The Long-term Risks to US Financial Markets

Bond yields are likely to rise gently this year, thereby causing a threat neither to equities nor to an overvalued housing market, as inflation is likely to dissipate for most part of 2004 and the Fed might delay its monetary tightening. In spite of market worries, both bonds and equities are near their respective equilibrium. However, there are serious risks to financial markets and the economy as a whole from fiscal policy turning once more easy in 2004. The Fed, then, would have a difficult job in keeping the economy on a sustained path to recovery. With strong growth, above potential, the Fed can afford to wait before tightening, as growth is likely to decelerate in 2005 and inflation is likely to remain muted. But the Fed would be forced to tighten more aggressively after the presidential election. Bond yields will rise in 2005 but not to levels that would undermine the housing market. The victim might be the equity market with prices falling precipitously revisiting the March 2003 levels, if the slowdown of the economy were sharp.