In 1981 the New Yorker published a cartoon. In it a man sat bemused as news reader attempted to explain what was driving financial markets witht the following circular argument:
“On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realization [sic] that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to a reimposition of higher interest rates”
Although the exact wording would be slightly different today, real life financial markets have continued to experience periods of volatility that would be just as confusing to onlookers and market participants alike.
By coincidence, it was also in 1981 that Robert Shiller first argued that markets were too volatile to be explained by genuine changes to the facts. Nowadays we think we understand more why this excess volatility occurs, with many (including us) believing that human emotion can play a significant role. However, that understanding does not make it any easier to predict price moves.
Just look at the confusion surrounding “tapering.” In May, without announcing any change of policy, beyond reminding the market that easy monetary policy would not continue forever, US Fed Chairman Ben Bernanke prompted violent market reactions. US 30 Year Treasuries saw peak to trough price declines comparable with those seen in 2003 and 1994, while emerging markets were also caught up in the panic.
In the aftermath of Bernanke’s speech markets have been indulging in the type of confused double and triple-guessing seen in the New Yorker cartoon. Is the creation of jobs in America a good thing? Or does it mean that the Fed is more likely to remove the support that has underpinned the economy (and asset prices) thus far? How much tapering is “too much?” What does the rest of the market think about this?
A few days ago, the Fed again surprised the market – by saying that nothing had changed.
This time equity and bond markets responded positively, while the news also prompted a flurry of emails from Fed-watchers apologising for being wrong (fortunately we had been treating their forecasts with the appropriate degree of scepticism in the first place).
At this point we remind ourselves of how little we know about anything, how hard it is to forecast these things and how complex the financial system is. Would it have been any more ridiculous for the caption to the cartoon above to have read?:
“On Wall Street in May, hints of tapering of QE initially sent the stock and bond markets down, but then hints from Ben Bernanke that the tapering would be data dependent sent the market up, until the realization that Middle Eastern tensions and rising oil prices pushed the market down again, before it ultimately went up on relief that the Fed had delayed the tapering”.