September 19, 2003

Why Are Financial Markets So Optimistic?

Morgan Stanley's Steven Roach wonders why foreign exchange traders, gibbering in terror as they look at the U.S. trade deficit, haven't dumped the dollar, pushing it down in value. He also wonders why bond traders, gibbering in terror as they look at the budget forecast, haven't pushed long-term interest rates up further:

Morgan Stanley: Which takes us to the critical question of the moment: What do financial markets see that the IMF and its like-minded sympathizers -- yours truly, included -- are missing? The main insight, in my view, is the presumption that global imbalances really don't matter at all. They are judged as the inevitable, benign, and even desirable outgrowth of yet another burst from the world's only real growth engine. For what it's worth, I continue to take issue with that key point (see my 2 September 2003 essay in Investment Perspectives, "Do Imbalances Matter?"). Imbalances, in my view, are tantamount to instability and fundamental disequilibrium. I would be the first to concede that such a state of disequilibrium is not life threatening in and of itself. But it does leave the economy, or economies, under question far more vulnerable to shocks than might otherwise be the case. To the extent such shocks are the rule, not the exception, I continue to be enamored with the case for an economic relapse in early 2004. Reading between the lines of the IMF's latest assessment of global risks, I suspect such an outcome wouldn't come as much of a surprise to them either.

I think I understand the bond market: some bond traders think that American fiscal policy is about to come to its senses again in the next two years, either because George W. Bush will be replaced by a competent president or because George W. Bush will be forced to delegate economic policy to some competent and Rubinesque Grand Vizier; other bond traders think that the recovery will stall and investment will remain low, hence there will be little demand for capital.

I also think I understand the relationship between bond market relative pessimism about investment spending and stock market optimism about profits and growth: they are different sets of people with different beliefs, and there are very few people with the money, the guts, and the risk tolerance to make the very risky long-term bets needed to try to make money off the inconsistency between the two sets of beliefs.

What I don't understand is the foreign exchange market. I would not be holding dollar-denominated assets right now without also holding a large derivative position insuring myself against a major downward move in the dollar. Yet there are no signs that foreign investors have taken on such positions--no sign that anyone who has sold them their dollar puts has taken steps to lay off the risk on the rest of the market.

Posted by DeLong at September 19, 2003 07:23 AM | TrackBack

Comments

America, like democracy, is terrible -- but all the alternatives are worse.
The Yen? Hah! Their banks are still secretly bankrupt, they're rich (enough) so why change?
The Euro? Right ... with the French and Germans both stuck with worse CAP and far worse, now mid-term looming pension crises.
Brad, you're worried about US unemployment? What about in the Euro-zone? (some 9% or something -- really, I don't know now. France & Germany both worse).

China and Russia and India (oh my!)? Still too small, too insular/inside, pull needed in gov't. But growing fast; still no capital shortage.

How about ... US real estate??? I don't think there's much undervalued; more likely overvalued.

So if the gov't doesn't tax & waste it, where else should it go? Where should investors invest?

(My advice: CEE - the accession countries, 60-120% of W. Euro quality at 40-60% the price. But I live in Slovakia, so am biased.)

Posted by: Tom Grey on September 19, 2003 07:42 AM

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On the domestic side, isn't this situation what you would expect from supply-side fiscal policy when the problem is too little demand?

Posted by: theCoach on September 19, 2003 07:52 AM

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Brad, you're a dollar denominated asset! If the slack in the US labour market would be temporary and the US productivity growth permanent, then the strong dollar is just fine! USA leads the cycle, so if the slack remains, world economy would be weak to, as Tom Gray hints at above.

I'm truly surprised at this dollar-meme, first Snow, then Brad, IMF, The Economist...

Posted by: Mats on September 19, 2003 08:11 AM

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Don't look now, but the dollar is having the tar whupped out of it the past two days. The BoJ has stopped intervening.

Now Brad,

"I think I understand the bond market: some bond traders think that ...." Did you ask them? 'Cause if you are just guessing what bond traders think, you're really just dreaming up ideas and attributing them to bond traders. Bond traders are quoted everyday on the wires. They have names and phone numbers and can be asked what they are thinking. I have not heard the "Grand Vizier" notion from anybody in the market. A stalling recovery, however, is a definite issue.

You have also dredged up one of those terrible notions used to explain what appear to be divergent indications from the debt and equity markets - "they are different sets of people with different beliefs..." Just dreadful. They are two different sets of people, and within each group there is sufficient diversity of opinion that it is highly unlikely one group will represent one view of the world and the other another. They will inevitably overlap. In fact, investors in one market are very frequently investors in the other. Mutual funds, pension funds, hedge funds, CTA, banks...

Why, absent direct evidence, would you ever believe that stock traders (who are to a sizeable extent just servicing orders for the above-mentioned groups) represent a view highly divergent from that of bond traders (servicing orders from the same croud)?

"there are very few people with the money, the guts, and the risk tolerance to make the very risky long-term bets needed to try to make money off the inconsistency between the two sets of beliefs." Hedge funds? CTAs? By assuming there are divergent views between stock and bond investors that have not been corrected in the market, you leave yourself little choice than to conclude nobody has the patience to take their money. But if the money is there to be had, why would nobody take it? Your assumption about the risk tolerance in the rest of the investing world does nothing to prove the assumption that stock and bond traders live on different planets. It grows out of that assumption and stands on the same rickety framework.

Some time ago, you offered an explanation of bond and stock markets simultaneously doing better. It had to do with the impression the Fed would continue to provide massive liquidity. Now, you're backsliding. Shame.

Posted by: K Harris on September 19, 2003 08:30 AM

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I was under the impression that a belief in efficient markets was prevalent among academic economists. Is my impression incorrect?

>>"I think I understand the bond market: some bond traders think that ...." Did you ask them>>

Why would you expect bond traders to tell you the truth? Sharing valuable information or insight is one sure way to dilute its value. People who make money by selling securities or services talk. Why would others?

Also, have you looked at the relationship between consensus forecasts and actual numbers. It ain't great. An illustration of the value of public info.

Posted by: richard on September 19, 2003 09:46 AM

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I don't buy into the Roach theory of Global imbalance. If I were to do a survey of my neighbors and find out most are borrowing and not saving or investing, should I declare a neighborhood imbalance? Of course not. The only rule of balance which applies here is that by necessity the borrowing my neighborhood does must be matched by investors living outside of it.

Roach likes to point out that the global situation today is lack of demand. All major economies have an ageing population saving for their retirements, and a lopsided distribution of wealth does not help demand either. This is the real imbalance... everyone wishes to save for the future and that can't happen. So a global economy has its way of sorting this situation out. It lowers interest rates until someone changes their mind about not spending, and in this case it occurred statistically more in the US. And why not? The US is least affected by a demographic problem, and maybe as a culture we are not quite as inclined to worry so much about the future.

So, we borrow at low rates to build houses and cars. Businesses make investments at low rates which keeps productivity gains strong. This is not even close to a problem. It is the invisible hand in action. I'm not willing to call the collective decision of Americans to take advantage of the situation now and pay it back later an impending disaster. Economies are fortunately behaving according to the laws of economics. Short rates are very low because the country/globe has too much savings at higher rates, longer rates are low for the same reason, and the stock market and housing prices are high for also the same reason. Within 5 or 10 or 15 years the populations of Europe and Japan, and probably the government of China will have decided that it's spending time and the opportunity for the US to go on a spending and investing spree will have ended. But we get to keep our houses (which last quite a while) and cars (for as long as cars last) and we get to keep our productivity gains too (until the equipment wears out). So I'm not worried. I'm not worried unless the Fed should run out of room to cut, and even then I'm not so worried.

Posted by: snsterling on September 19, 2003 09:49 AM

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K Harris writes:
>
> Don't look now, but the dollar is having the tar
> whupped out of it the past two days. The BoJ has
> stopped intervening.

Hey, you're not kidding. This week the yen has been up 3% vs. the dollar, with 2/3 of the difference being yesterday and today. On the other hand, a news story or two suggests that the lack of intervention may be related to the imminent G7 meeting, where the currency intervention question will be a big topic of discussion.

So how far and fast could the dollar drop if the G7 announces they'll sit on their collective hands?

Posted by: Jonathan King on September 19, 2003 10:57 AM

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Richard,

Bond traders tell the truth? Yes, almost without question. Once they've put on their trade, they won't want you to know their position for fear that a big, bad guy could come along and make that position very painful. That is very different from asking them how the world looks. Their opinions about the direction the economy is likely to take is almost without value as "information" in an efficient markets sense. If the weight of opinion is shifting, and you can learn the direction of that shift before it is priced in, then you can capitalize. That would be a heck of a trick. You cannot capitalize on news that is already in the market, such as the fact that one trader or one desk thinks growth will remain strong or that the Fed will hike rates in July rather than March. That valueless information is largely what you would get if you called up 5 traders at the end of the day and asked their view of the economic and interest rate outlook. It would, however, make speculation such as Brad's unnecessary.

As regards the value of forecasting misses and public information, if the median estimate for August durable goods orders is for a 0.6% rise, then a higher or lower result tells you whether that leading slice of the economy is doing better or worse than generally expected. Trading the data is not a game in which most folks play to be right (though there is enormous interest in who has the best record on any particular data series). It is a game for the quick, who trade the difference between the expected and actual outcome. There is enormous value in the median estimate, even though it is publicly held, because you'd be at a disadvantage if you didn't have it.

Posted by: K Harris on September 19, 2003 11:25 AM

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Always always separate stock and stock market movement and trend from "economics." When the opportunity is there we settle for long term investments and pay no mind to economic conditions. Price a stock well relative to what we think earnings and earnings growth will be, and we buy. Why should I worry about the economy in buying Merck or Intel when the value is attractive?

With bonds we do look at the economy, but since we prefer stock we buy or sell bonds when valuations tend to extremes. Again, there is no reson to be dead right about the economy. In October 2002, the 10 year treasury yield dropped to 3.65, while high yield debt sold off sharply on top of a 3 year continuing sell-off. Defaults had peaked, so we sold long bonds and bought a basket of high yield.

Posted by: anne on September 19, 2003 11:50 AM

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The gold market hasn't been sitting still.

Posted by: Dave Johnson on September 19, 2003 02:35 PM

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Dave,

If you take the price of gold denominated in Euros, it hasnt risen as much.

Ditto for oil.

The story is one of nominal price rises being offset by a fall in what they are being measured by.

Ian Whitchurch

Posted by: Ian Whitchurch on September 19, 2003 03:14 PM

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Timely comment, the dollar is trading lower compared to the yen. It dropped through a floor today.

Posted by: bakho on September 19, 2003 03:17 PM

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K harris, you seem rather worked up about something for which there is plenty of evidence: that bond investors and stock investors do not always think the same ways. We have decades of track records to look at, and they tell us that the people who buy and sell bonds do think differently than the people who buy and sell stocks (even if they are the "same" people; people are known to be inconsistent).

That doesn't make Brad right or wrong about the ways that we should interpret the current bond trading climate, but that is a different matter than denying that the markets often behave differently.

Posted by: howard on September 19, 2003 03:38 PM

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The market is a crowd. First it edges toward the exit then it panics. Everyone gets killed in the rush. The point is once the rush starts there is nothing to stop it in todays economic situation and nobody to stop it in the current administration.

Posted by: Josh Halpern on September 19, 2003 07:30 PM

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I agree with those who take BDL to task for his ad hoc suggestion that bond and equity investors are operating with different sets of assumptions. I would try out another story.

Investors generally are aware that there are headwinds impeding aggregate demand growth and that these headwinds will have to be offset with a prolonged period of "accommodative" monetary policy. Accordingly, the forward path for the funds rate is depressed over an extended maturity range, which has implications for long-term Treasury yields. To wit, fully appropriate forward bond yields interact with the Fed outlook to generate seemingly depressed spot yields. The simplest way to confirm this is to check the yield on eurodollar futures out beyond at the 09 maturities. You will see that they imply a real funds rate that is near the PEAKS reached in the late 1990s, even after adjusting for plausible eurodollar term premia. So bond yields look depressed only if you reject either the logic of arbitrage or the premise that the Fed stays on hold for a long time.

What about stocks? Low spot bond yields depress the discount factor in the equity market, but expected earnings growth is NOT commensurately lower because investors, all investors, expect the policy accommodation to WORK and thereby support reasonable earnings growth. (Indeed, to the extent that cost cutting is one of the headwinds that the Fed is successfully leaning against, this story may imply an unusually bullish cyclical path for earnings.) Hence equity valuations rise to levels that are appropriate relative to (real) bond yields prevailing today.

Perhaps equities may seem expensive relative to so-called "normalized" bond yields, in which case my consistency argument might seem to break down. But as I already explained, the term structure is by no means implausible or inconsistent with the economic outlook -- and so it is not clear that cash is preferable to bonds or, by extension, stocks. Rather, bonds look ok relative to cash and equities look ok relative to bonds, and all may be anchored in a coherent outlook for the economy and monetary policy.

Maybe investors are wrong. They usually are. But in my opinion, there is little reason to believe that different classes of investors are operating with different sets of assumptions. (Just ride the bar car on the New Haven line some day.)

What about the potential steep drop in the dollar? In my opinion, the dollar is toast, mainly for the reasons BDL mentions. But I don't think BDL is right to argue that the bond and equity markets are blithely ignoring the implications of a much weaker dollar. After all, the dollar doesn't even know that it is kaput yet. How can the 10-year Treasury or S&P500 be expected to?

Posted by: Gerard MacDonell on September 19, 2003 08:14 PM

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What could happen if the global demand remains constant, even after the boost of investments due to the low interest-rate, this measure involving "de facto" a soaring productivity?

Posted by: Flep on September 20, 2003 07:15 AM

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What happens then as the dollar falls in value and China keeps the currency peg? Well, China will keep the dollar peg and become even more competitive. For just this reason, I doubt there will be another significant dollar decline just now. The dollar began the year at ~118 yen, stayed quite stable, but has fallen midly these past few days to about ~115 yen. Since the Japanese increasingly ship products from China and India, the change in currency value is really of slight consequence as yet.

Posted by: anne on September 20, 2003 11:08 AM

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The matter has two points. First the bond/currency correlation that was striking in the 90's is less so. Homogeneous growth rates, interest rates and the Euro have made that so.

Seond point, deficite don't matter too much, particularly if the imbalances are perceived as short term in nature.

I have been a currency trader for most of my career, and an asset manager. My view is that US assets are still a much better investment than assets in other places. Whar economy and markets are likely to rebound sooner or more sharply or more durably than the US?

The Euro is still a suspect currency. (It also still rank form a political perspective.) What is a proper reserve currency? So why would I be a dollar seller when no other currency looks more attractive?

Posted by: Tom Barman on September 20, 2003 03:04 PM

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The matter has two points. First the bond/currency correlation that was striking in the 90's is less so. Homogeneous growth rates, interest rates and the Euro have made that so.

Seond point, deficite don't matter too much, particularly if the imbalances are perceived as short term in nature.

I have been a currency trader for most of my career, and an asset manager. My view is that US assets are still a much better investment than assets in other places. Whar economy and markets are likely to rebound sooner or more sharply or more durably than the US?

The Euro is still a suspect currency. (It also still rank form a political perspective.) What is a proper reserve currency? So why would I be a dollar seller when no other currency looks more attractive?

Posted by: Tom Barman on September 20, 2003 03:09 PM

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The matter has two points. First the bond/currency correlation that was striking in the 90's is less so. Homogeneous growth rates, interest rates and the Euro have made that so.

Seond point, deficite don't matter too much, particularly if the imbalances are perceived as short term in nature.

I have been a currency trader for most of my career, and an asset manager. My view is that US assets are still a much better investment than assets in other places. Whar economy and markets are likely to rebound sooner or more sharply or more durably than the US?

The Euro is still a suspect currency. (It also still rank form a political perspective.) What is a proper reserve currency? So why would I be a dollar seller when no other currency looks more attractive?

Posted by: Tom Barman on September 20, 2003 03:09 PM

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"Deficits don't matter too much, particularly if the imbalances are perceived as short term in nature."

Makes sense, but these deficits are not short term and should be quite scary whatever the current perspective. We have a severe saving and deficit problem that will haunt us for years though probably not for a while.

Posted by: anne on September 20, 2003 03:38 PM

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Who are you guys referring to when you refer to bond traders? The guys setting the prices? Those guys are (or at least should be) largely setting prices in accordance with supply and demand and making money off the bid-ask spread.

So the question is, who are the movers and shakers in the bond market? Prop desks? Hedge funds? Insurance companies? Retail and institutional money managers? Someone/something else? I don't have a full grasp of the dynamics of the bond market. Obviously the US treasury yield curve does change shape during trading hours.

I would say, from personal experience, that in institutional fixed income, you don't usually bet on the direction of the market; you hedge away interest rate risk via duration matching against your index. We were basically given x amount of money, and were expected to beat some index by n basis points. So our investment decisions should be yield-curve neutral.

However, the person(s) (say, for example, at CALPERS) who calls the shots in deciding whether to allocate x percentage of their money to some particular asset manager, probably has a lot of power in moving markets. But how often, easily, and quickly can they shift their allocations? I'm not sure.

Other than that - I guess hedge funds can have large amounts of leverage and move markets. But who else? (I guess I should have asked my old boss these questions back when I had the opportunity).

Posted by: ETC on September 21, 2003 03:28 AM

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Most pension funds and the like begin with indexing and may manage some bond holdings to gain an edge on the general index. What there is in bond derivatives at JP Morgan and others is quite a question. The question will be when there comes a perception that America has a saving and deficit problem and how investors take account of that.

Posted by: anne on September 21, 2003 06:41 AM

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Unusual ideas can make enemies.

Posted by: Goldberg Myla on December 9, 2003 10:51 PM

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All sentences that seem true should be questioned.

Posted by: Ruta Domenica on December 10, 2003 10:59 AM

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Make all you can, save all you can, give all you can.

Posted by: Primack Gretchen on December 20, 2003 03:04 PM

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I dont know what to say, but i likeed it.

Posted by: Mellquist Nils on January 9, 2004 02:37 AM

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