Explaining the bond market selloff: Traders versus economists
Jul 11th 2013, 21:34 by G.I. | WASHINGTON, D.C.
Traders and economists both spend their days studying markets, yet I’m struck by how differently they approach the subject. Since traders profit from finding mispricings, they are biased to believe that prices are more often wrong than right. Fundamentals matter, but traders believe they are routinely overwhelmed by psychology, liquidity and other non fundamental factors.
Economists, by contrast, grow up believing prices are usually right. The intersection of supply and demand curves explains in elegant, intuitive and internally consistent fashion how each individual buyer and seller can have a different idea of what a price should be, yet their interactions collectively yield a single, objectively correct price. Economists don’t dispute the role of psychology – they’ve handed out Nobel prizes for precisely that – but the organizing principle of their lives is that market prices are usually an unbiased distillation of fundamental determinants.
These different world views help explain why traders have always been suspicious of quantitative easing (QE) and economists dismissive of those suspicions. Stan Druckenmiller, for years a remarkably successful hedge fund manager, in May accused the Fed of “running the most inappropriate monetary policy in history.” The Treasury bond yield, he argued, was the most important price in the economy and QE was contaminating that price, allowing countless other assets to deviate dangerously from sensible levels. Economists Brad DeLong and Paul Krugman chalked traders’ criticism up to sour grapes: they had tried to profit from the mispricing QE caused, and lost.
I will admit at the outset that on most matters, I’m with the economists (hey, look who I work for). Every price results from two smart traders taking opposite positions, so my world view relieves me of having to take sides. Yes, QE manipulates a price, but every monetary policy regime manipulates something: the price of gold, the exchange rate, the short-term interest rate. In the case of QE the manipulation is transparent: it is done by altering supply and demand rather than directly controlling the price, the monetary equivalent of holding down rents by building new apartments rather than rent controls.
Yet it’s worth listening to the traders, and the carnage in the bond market over the last month explains why.
First, economists are always trying to model the behavior of traders, even if they don’t know it. For example, consider the orthodox models of security valuation. A stock equals a company’s future cash flow, discounted by some risk free interest rate plus an equity risk premium. A ten-year bond yield is the average of expected short-term rates over the next 10 years, plus a bit extra called the “term premium.”
Equity risk premium and term premium sound like sophisticated economic concepts, but in reality they are statistical junk yards into which economists toss stuff they can’t explain with fundamentals. In essence they are amalgams of all the murky, unquantifiable factors traders study in their perpetual search for mispriced markets.
When the Fed set out to prepare markets for a slowing in the pace of QE in May, it assumed that because it was not altering its guidance of when it would raise short-term rates, bond yields would only back up a bit. Instead, they have shot up a full percentage point and futures markets, which arbitrage between short and long-term rates, reflected a much earlier start to rate hikes. This, Fed officials concluded, was a serious communications problem: markets had wrongly thought less QE also meant earlier tightening, and officials have been trying ever since to clarify that it does not. Last night Ben Bernanke, the Fed chairman, went so far as to say rates could actually stay low longer than the Fed had previously indicated, especially if inflation didn’t move back up to 2%.
In fact, the premise that the bond market has sold off because of miscommunication is highly suspect. Before each FOMC meeting the New York Fed surveys primary dealers. The survey for June released today found their median expected date for the first increase in rates is the third quarter of 2015, no different from April. (See postscript below.) In other words, traders have not revised their view of when the Fed will start to tighten (unless the people filling out the surveys are at complete odds with the folks at the next desk trading bonds).
So if expected short-term rates haven’t changed, by definition bond yields have shot up because of higher term premiums, or in other words, stuff traders are doing. Exactly what, I’m not sure. The bottom line is that an enormous amount of money had to migrate out of positions premised on low long-term bond yields. Perhaps no one thought so large a selloff was necessary, but each player sought to move before everyone else did. This dynamic is not easily modeled by economists, but it matters. The economy so far looks okay, but not if yields rise another percentage point, which would be consistent with a normalization of term premiums.
The fact that non fundamental factors can be such powerful movers of markets is not a reason to let traders dictate monetary policy; it’s a reason to consider the views of traders when interpreting prices and formulating policy. Jeremy Stein, a Fed governor, straddles these two worlds quite ably. In a recent speech, Mr Stein said:
[F]undamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call “changes in discount rates,” which is a fancy way of saying the non-fundamental stuff that we don’t understand very well–and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics.
I don’t in any way mean to say that the large market movements that we have seen in the past couple of weeks are inconsequential … My only point is that consumers and businesses who look to asset prices for clues about the future stance of monetary policy should take care not to over-interpret these movements.
The same goes for central bankers, bloggers and journalists.
Postscript: After surveying primary dealers before the June FOMC meeting, the New York Fed resurveyed them right afterwards and found the median expected date for the first rate increase had moved up, to the second quarter of 2015, from the third. This is still later than implied by futures markets.
The original post is linked here.