MarketWatch: July 19-23

As of mid-morning Friday, U.S. and overseas markets await the results of the stress tests conducted on European banks, to be released at noon. Based on the Fed’s stress tests of U.S. banks, the idea is to give markets credible information (and presumably assurances) about the financial condition of individual European banks, which have been under great pressure from the fiscal crisis in the eurozone.

The stress test results are also important for U.S. financial markets, which have critical linkages to European financial markets in our era of global capital. Important global capital relationships underpin our financial sector funding, trade, and investment flows.

But we fiscal wonks have seen a downside of these linkages. Important spillover effects from the eurozone fiscal and financial crisis have lowered US interest rates more than U.S. economic fundamentals would warrant. Investors seeking a safe haven in the face of increased – but unknown – risk from the eurozone, have turned increasingly to Treasury debt instruments in what is often called “a flight to quality”. As a consequence, we have been able to finance our massive debt far more easily than otherwise. While in some ways this is a good thing (U.S. debt service is cheaper and so needed stimulus measures have cost less than in normal times), the bottom line is that it makes us all think that debt has no cost. Fred Bergsten of the Peterson Institute for International Economics has led the chorus in saying that maybe we shouldn’t be so fortunate that our massive debt is financed so easily. Yields on government debt this week remain unusually low (at the long end, below 3 percent for the 10-year note and below 4 percent for the 30-year note) as a result.

Among factors driving the markets this week have been concerns that the US economy is slowing more than expected (and may be slowing relative to Europe, which had a series of better than expected economic news). Chairman Bernanke’s semi-annual monetary policy report to Congress this week drove sentiment here – which was confirmed by persistent weak housing and unemployment reports. Some reports suggest that markets are concerned about deflation, but trading positions do not yet confirm the worry.