London, 28 July 2010

There has been just an inkling in recent weeks that financial markets might start to take their lead from the 'real' economy again after three years of being tossed about by their own panics and periodic exuberance.

Since the finance industry flailed into its crisis of confidence, doubting its own practitioners and the governments who became over-dependent on them, it has been almost impossible for households and companies to work out what markets are trying to predict about production, employment and consumption.

The net result has been the tail wagging the dog. Guess the ephemeral mood of global markets six months hence -- voracious risk appetite or bunker-seeking safety -- and you might just stand a chance of predicting where businesses, consumers and policymakers would be forced to follow.

And while PIMCO asset managers predict a post-crisis 'new normal' of years of sluggish growth and policy angst, many yearn for an 'old normal' where finance reflects, rather than dictates, what is happening in the real economy where people produce and consume goods and services.

A VERY FINANCIAL COUP

For some, the credit crisis and aftermath had been fomented for decades by a more than a doubling of financial services to some 7.5 percent of the U.S. economy in the 40 years to 2007. "The 3 percent of GDP (gross domestic product) that was made up of financial services in 1965 was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20th century," Jeremy Grantham, Chairman of Boston-based asset manager GMO, told clients this month.

Lauding this month's U.S. financial regulation bill, he added: "The extra 4.5 percent would seem to be without material value except to the recipients. Yet it is a form of tax on the remaining real economy and should reduce by 4.5 percent a year its ability to save and invest, both of which did slow down."

Former International Monetary Fund chief economist Simon Johnson's 2009 Atlantic magazine essay, "The Quiet Coup", took a more conspiratorial view of the same phenomenon in sketching the lobbying power of the financial industry over that period.

Johnson estimated U.S. financial sector profits, which had never topped 16 percent of overall corporate profits in the decade to 1985, soared to 41 percent by the noughties. Average financial sector compensation as a share of the average in other industries almost doubled to 181 percent. There was a similar development in Britain, where financial services had reached 8.5 percent of total output just before the crisis.

Deregulation, privatisation, trade globalisation and demographic trends were all catalysts for this growth in finance and the current regulatory backlash against the banks is unlikely to return the sector to its 1960s size. But if knocking the froth off finance allows a more even relationship between real economic trends and financial markets, there may be a chance of tempering the endless boom and busts.

CHANGE AFOOT?

Is there any sign of that happening right now? Well, just an inkling. In the past three years, financial and investment flows have been violently herded in and out of "safe-haven" cash and liquid assets, correlations zoomed between all asset classes and geographic regions, and risk gauges -- largely volatility measures -- careened from historic lows to highs and back again.

This mass behaviour had been building for 20 years. Computer trading strategies supercharged the effect over time. Yet as this year's euro zone sovereign debt crisis ebbs into the second half of the year, the herd seems for now to have stopped stampeding from its own rifle shots and may be listening more carefully to the underlying economy again.

Mindful of near-zero interest rates in cash, an expected dash back to safe-haven money market funds never really materialised during the worst of the euro crisis in April and May and 2010 outflows from these funds are still close to half a trillion dollars. Partly as a result, stresses evident in lock-step asset correlations have ebbed and investors seem easier with idiosyncratic trends in selected stocks and credits.

Equity volatility has halved from April/May peaks and quartered from post-Lehman Brothers highs in 2008 and is holding closer to 20-year averages just above 20 percent rather than returning to unrealistic pre-2007 levels in single digits.

Even the world's main exchange rates between the U.S. dollar and euro -- long captive to "risk on/risk off" swings - are starting to reflect interest rate gaps more than stress. For active and diversified investors, this is how it is supposed to be and allows them to do what it says on the tin.

To be sure, we've been here before. But there are rays of hope for some return to old normals.

Ends --

By Mike Dolan, Reuters - for Commodities Now.