For a long time after 2008, asset prices suggested that most investors believed low interest rates to be temporary. The most common view, whether conscious or subconscious, seemed to be that once we were ‘out of the woods’ things would return to normal.
We have written before about how this belief has been deeply challenged. However this year has seen an even more profound shift in expectations.
The chart below shows short term interest rates implied by US swap instruments. It shows that in 2008 (at the start of the dotted green line), it was implied that interest rates would be back to around 4% by 2016. You can see how the long term rate expectations have declined since the financial crisis, and particularly since 2014.
Today, the figures imply that cash rates will be 1.4% in 10 years’ time, about 1% higher than they are today. Contrast that with beliefs in 2009 (the red line), when rates were at lower levels than they are today but the market believed equilibrium cash rates to be closer to 3%.
A changing narrative
Swap rates aren’t a perfect measure of where people believe rates will end up, but the charts above are consistent with changes in economists’ forecasts, yield curves, and even changes in the Fed’s ‘dots.’
They are also consistent with the stories we tell ourselves about how markets have changed. Nowadays there are fewer articles claiming “the Fed is behind the curve”, “the US is in a bond market bubble”, and “the economy is at danger of overheating”.
However the number of articles mentioning “secular stagnation” (as we mentioned last month) and “low expected returns” has risen significantly.
Why the change in view?
Why may investors have given up on the idea that low rates were temporary and adopted a firmer belief in the new normal? The US economy has improved over the period. In fact, if the Fed had applied the Taylor rule – which provides a guide to where rates ‘should be’ based on inflation and economic activity – then rates would indeed be more ‘normal.’
Similarly, economic growth in the US and the world are below their medians over the last thirty years or so, but drawing a confident conclusion that these dynamics are structural rather than cyclical seems premature.
It may be that markets are being highly prescient. There are many highly convincing arguments for a low growth, low interest rate world. Larry Summers outlines six reasons, Austrians would argue that low rates themselves damage long term growth prospects, Marxists feel that underinvestment and low growth is the inevitable result of capitalism.
A behavioural interpretation
However, history does not suggest that markets reflect a considered weighing up of the merits of various academic arguments. Rather, it seems that even with the rise of passive and ‘robo’ investors, market dynamics still resemble a social network made up of individuals exhibiting behavioural biases.
In the early years after the financial crisis, we tended to hold on to our prior beliefs about how the world worked. Thinking about the long term is too hard and so we often fall back on representativeness and anchoring in the belief that the future will look like the past.
How we come to jettison these views is a deeply complex process. At an individual level, we can often feel emotionally attached to our views, and it can become very difficult to discard them. In fact, as this excellent article highlights, evidence suggests that being confronted with factual evidence only strengthens our views.
As a collective, the process for changing views becomes even more complex. In social networks, tipping points, peer pressure and group identities all play interconnecting roles. Added to this is the fact that, like value investors in the tech bubble, many investors backing against the trend will have had to adjust their views or lose their jobs. Not only are group dynamics complex, but the cohort itself is changing.
Behavioural psychology is making some advances in group dynamics and how groups change their minds, particularly with the rise of big data and social media. However, finance seems to have paid less attention to this, with work on capitulation largely limited to technical trading rules.
So what can we say about why views have changed recently? Our observation is that markets become more prone to herding when investors have their world views challenged. If you can’t be sure about your model of how the world works, why take the risk of backing non-consensus views?
It also seems that a belief in the safe haven properties of government bonds has been strengthened by the long term trend decline in interest rates.
These related observations suggest that rather than embracing a strong belief in the new normal, recent price action reflects the market’s ongoing uncertainty and stress in the face of surprising outcomes. If it is the case that price moves are not grounded in conviction then it has implications for how vulnerable they could be to reversal. Assessing the interplay between investors’ long term beliefs and short term motivations will be an important aspect of multi asset investing the year ahead.