The stock market is not the economy - but the wild ride of the last 3 days is telling us something really important

Reuters

• This massive stock market selloff does not mean there is something wrong with the economy.
• But it is telling us that the world is a riskier place.
• Some economists might call this the end of a cycle of trust.

For days, since the stock market's brutal selloff on Friday and Monday followed by a Tuesday marked by wild swings, this has been the conversation going on in offices across global Wall Street:

Traders, who had been levered up to their eyeballs, are speaking to their risk managers. And their risk managers are explaining that, according to the new model that factors in a new economic reality, they'll have to borrow less money to play in the market.

Volatility, these killjoys will say, has returned. After laying dormant for months, the VIX, Wall Street's volatility index, has roared back to life.

"The VIX is now pricing the equivalent of a 2% S&P 500 move up / down each day for the next month," according to the Chief Investment Office at UBS Wealth Management. "The market-implied probability of another sell-off in excess of 5% over the next two weeks is about 25%."

In other words, even after the dust settles from the breathtaking selloff we just saw, we'll still be living in a riskier world.

Every man for himself

Now, the stock market is not the economy. The economy is doing well. But investors are in fact adjusting to very real changes in economic conditions. It's a world that's growing faster, but with more risk.

This is a moment Wall Street has been waiting for since the financial crisis. Not because stocks were overvalued, or because of a Trump rally, or because tax cuts were priced in.

Instead, we have reached the end of an economic cycle of trust.

Some economists, specifically Martin Nowak, a mathematical biologist at Harvard, believe that markets move in cycles of cooperation. When everyone's working together for a common goal, we get rich. Then bad actors realize they can game the system, and start misbehaving. Trust breaks down and suddenly everyone is sniping at everyone else. The market becomes riskier until cooperation is seen as the only remedy. Then the cycle starts again.

For years the entire world has been coordinating its interest rate policies, working together to ensure a uniform gravitational pull for money around the world. If that's not cooperation, I don't know what is.

But as growth takes hold, bringing inflation with it, central banks will have to start looking out for themselves. If inflation in the US does pick up faster than expected, and the Federal Reserve decides to raise rates based on the health of our domestic economy alone (not the world's), that will shift the gravitational pull of the financial universe.

For central banks, saving the world from getting sucked into a deflationary pull by keeping rates low is no longer their singular concern. It's every man for himself.

Y'all are late

Back in 2014, Dylan Grice, a portfolio manager at Aeris Capital, wrote a paper on this cycle of trust theory at a time when markets were riding high, but the world was looking riskier. Russia had just invaded Ukraine, and corporations were suing one another or being sued at a record rate.

At that time though, central banks were working in a cooperative mindset, coordinating their efforts to ensure maximum global stability through interest rate control.

"What we do think we know is that financial markets are playing with a very cooperative mind-set while the key players and factions in the outside world are not," Grice said. "Non-cooperators are on the ascendancy and the investment climate will soon reflect this."

That brings us to today, when inflation - a force unseen really anywhere on the planet since the bottom dropped out in 2008 - has returned. That could inject uncertainty about interest rate policy into what was our incredibly stable mix, creating an environment where central bank cooperation will no longer serve as a buffer against the realities of the world.

Interest rate policy is not the only place where we can observe cooperation fraying more dramatically thanks to inflation. Consider the weakness of the US dollar, another piece of the inflationary puzzle. Its weakness already has some on Wall Street warning of a "cold currency war," with an administration making unconventional statements about the strength of the dollar injecting a new level of uncertainty around the world's reserve currency.

I'm not saying that all these risks are going to bring us down. I'm saying that our defenses are lower now. Everyone in the market has new risk factors to consider. This is what Wall Street is spending days of horror reimagining.

The market is not an omniscient indicator of the future; it is a survey of the way we think of the future in the present. So with that in mind, tell me. Haven't you felt like the world is a more unforgiving place lately?