June 09, 2003

New Online Column From the Economist

The Economist is starting a new online column about the daily ticking and tocking of financial markets.

Economist.com: AN ODD thing is happening in the market for risk and the market of the riskless, also known as the equity and government-bond markets: prices are rising in both. The S&P 500 share index, up by over 20% from its low earlier this year, continues to soar. Meanwhile, rising prices in the bond market have driven yields on the ten-year note down to 3.35%--a level last seen when Elvis Presley was a youngster. The same, broadly, is true in Europe: both stocks and government-bond prices are up.

It has happened before, of course; indeed, there have been long periods where the two have moved in tandem, in part because lower interest rates reduce the financial burden on companies and make investment cheaper. But the coupling is a perplexing one right now, nonetheless, because the reasons that investors are buying the two markets appear to be diametrically opposed: in effect, bond-market investors seem fearful that the American economy will remain sluggish, while the equity market thinks it is over the worst...

Such a column is a hazardous exercise to undertake. It violates Bob Rubin's third rule: do not be quick to overinterpret daily or weekly movements in asset prices.

Moreover, the Economist does not seem to give what I think is the most likely explanation for what is going on. I think that what is going on is that financial markets are changing their view of what the Federal Reserve's Monetary Policy Reaction Function is. Because of statements by Chairman Greenspan, they think the Federal Reserve now has in mind a more liberal and expansionary rough rule for setting interest rates as a function of the unemployment rate.

Such a systematic bias toward easing raises bond prices: no matter what you had thought the path of unemployment was going to be, now you think that interest rates will be somewhat lower than you had thought three months ago. Hence bond prices rise. Such a systematic bias toward easing raises stock prices: lower interest rates mean lower unemployment, higher demand, and higher profits as well as lower discount factors on future corporate earnings. Hence stock prices rise.

More interesting, I think, is a surprisingly large narrowing in risk and default-driven interest rate spreads that has been ongoing for a while...

Posted by DeLong at June 9, 2003 03:26 PM | TrackBack

Comments

What are Rubin's other laws?

Posted by: Ted Arrowsmith on June 9, 2003 04:19 PM

Ah. That I never found out...

Posted by: Brad DeLong on June 9, 2003 06:38 PM

Never found out??!!! Not fair! Not fair! Not fair!

But back to the issue at hand. My first thought when I began to read your description of the Economist's new thingie was much the same as yours. Efforts to render meaning from daily market moves is often not very useful, other than to note who was buying and who was selling. (Positions really matter.) However, the example offered doesn't really try to decipher a single day's trade. And, to my relief, I see the header to the articles says the Economist will write "on the trends that lie behind the daily ups and downs." To be trends, these things have to persist for a while, and are more prone to analysis than one day's up and another day's down.

Still, the Economist manages to fall into another trap. One often reads that disconnects between the pricing in different markets means that participants in those markets hold different views of the world. That is a very odd assertion. If there were two or three participants in each market, that view might make sense. In fact, among the many thousands of participants, there is substantial overlap among participants in all markets. How can stock investors differ substantially in their economic outlook from bond or currency or mortgage traders?

Now, if there were a factor that could boost prices for bonds and stocks simultaneously...

Posted by: K Harris on June 10, 2003 05:23 AM

"Efforts ... is.."? Stupid me.

Posted by: K Harris on June 10, 2003 05:32 AM

Agreed. But, is there a dis-connect now between stock and bond markets? The stock market is discounting the best of worlds, the bond market the worst. Are stock prices simply rising because bond prices are rising?

Anne

Posted by: anne on June 10, 2003 12:37 PM

Robert Rubin always held the bond market showed us more about economic health or weakness than the stock market. We are seeing bond prices that no one would have guessed at in 1999 or 2000. Health or weakness? If weakness, how significant?

Posted by: anne on June 10, 2003 12:42 PM

The LIBOR curve is now inverted to one year out. Draw your own conclusions. This as easy a stock market to play as I have seen in my limited experience.

Posted by: JT on June 10, 2003 12:44 PM

The LIBOR curve is now inverted to one year out. Draw your own conclusions. This as easy a stock market to play as I have seen in my limited experience.

Posted by: JT on June 10, 2003 12:49 PM

Agreed.

Trade, trade, trade. I love this stock market, but I am now taking profits readily and trading to better valued issues.

Posted by: bill on June 10, 2003 01:06 PM

Brad is spot on. Bond markets are systematically discounting a fed easing in the near future. stock markets are discounting an 'inevitable earnings growth'.

the views are actually divergent: bond markets are thinking that things are so crappy (and the equity guys are so nutso) that interest rates have to be lowered.

the equity guys are calling for a bottom, but will gladly take a rate cut as gravy.

Then there is also the phenomenon of consumers finding their money market returns so miniscule that they are willing to assume some risk chasing more return.

Posted by: Suresh Krishnamoorthy on June 10, 2003 01:21 PM

Brad is spot on. Bond markets are systematically discounting a fed easing in the near future. stock markets are discounting an 'inevitable earnings growth'.

the views are actually divergent: bond markets are thinking that things are so crappy (and the equity guys are so nutso) that interest rates have to be lowered.

the equity guys are calling for a bottom, but will gladly take a rate cut as gravy.

Then there is also the phenomenon of consumers finding their money market returns so miniscule that they are willing to assume some risk chasing more return.

Posted by: Suresh Krishnamoorthy on June 10, 2003 01:26 PM

my suggestion for the name of the column: "eye on the market" :D cuz, what's up with that creepy eye chart?

we shall see!

Posted by: kenny on June 10, 2003 02:31 PM

Bond markets are high because other conservative vehicles like CDs are not much better than stuffing money in a matress. Stock market is in a secular bear. However, within a bear market, stocks do have runs. The current run is being fueled in part by administration claims that the dividend tax cut will deliver a 15+% increase in stock prices. I don't believe it but this is what the Bush administration has been claiming. This is creating the current upward irrational exuberance. I would join the run but be very quick to pull the plug since stocks are way overvalued at current prices, dividend tax or no. The hedge funds are helping to fuel the current run. At the end of the day we will wander back down to Dow 7000. Investors always do better under Democratic administrations, even though they usually vote GOP.

Posted by: bakho on June 10, 2003 09:49 PM

OK, I'm gonna try again. A bunch of professionals in an industry that has been shedding jobs like crazy is, according to a number of posts in this series, simply getting it all wrong, despite the obvious risk this represents to their livelihood. Meanwhile, folks who are by and large paid to do things other than invest money in financial markets stand on the sidelines and see very clearly what is going on. This is not clear thinking.

I earlier offered the notion that we ought to look for an explanation that doesn't require "bond investors" to see the world very differently that "stock investors" in part because there is large overlap between the two classes. Even if you don't like that idea (I'd like to hear well reasoned objections, though), there has to be a better explanation for what is going on than that stock traders have been tricked by a transparent political claim. bakho seems on the right track. If you are a money manager, you have to put that cash someplace and, even if bonds are in for a bashing a few months from now, the yield curve is steep, so you buy bonds. Even if stocks are in for a bashing, most mixed portfolios still have a pretty hefty mix of stocks in the prospectus, so you buy stocks. If conditions warrent an ease, then the argument is stronger for bonds than stocks. If not, then the argument is stronger for stocks than bonds. In either case, the widely anticipated ease should be good for both. Unless my memory is fading badly, the joint rise of stocks and bonds coincides fairly closely to the fed funds curve pricing in strong odds of a June ease.

Posted by: K Harris on June 11, 2003 12:50 PM

Didn't Soros huge short bet a while back demonstrate that in the stock market it pays to be right in the short term, and that, even if you are dead on in the fundamentals, you can lose out if the market does not move quickly enough?
K Harris, I would be very interested in your predictions about what this means for the next couple of years. Thanks.

Posted by: theCoach on June 12, 2003 05:26 AM
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