Sometimes the market is seen as an almost mystical force, sending signals that give us special insights about the future if only we can decipher what it’s ‘telling us.’
Other times it’s characterised as a naïve and careless basket case, subject to the lack of judgement and greed of the masses.
Both these characterisations of markets are in evidence today. The rallying bond market and inverted yield curves are seen as providing clairvoyant warnings about an inevitable recession, while equities and other risk assets are seen as reflecting irresponsible gambles.
How reasonable are these two characterisations of markets? Do markets contain hidden knowledge, or are they comically naïve? Do they move from one state to another? Can they do both?
More topically, as discussed by our colleagues at the equities forum last week, just how much of a contradiction is it to see rallying bond markets suggesting caution, and positive returns from growth sensitive assets apparently ignoring these warnings?
The bond market is one of the most common areas to be seen as having some sense of clairvoyance in the signals it gives. Commentators pore over shifts in the bond market and yield curve to divine a prognosis for economic outcomes.
Implicitly these market indicators are treated like exogenous variables: exogenous in that they are seen as new pieces of information in themselves.
This is plainly incorrect framing. The reality is that yield curves are set through the collective beliefs and actions of all market participants. That yield curves are inverted only reflects the expectations of market participants based on the news we already have, their inversion is not itself an additional piece of news. As John Williams of the Federal Reserve argued they are not a magic ‘oracle’ for predicting recession.
Bond markets and the yield curve are very much endogenous variables and need to be treated as such. When longer dated Treasury yields are below the policy rate (as on the left hand chart on Figure 2 above) it tells us that the market expects a rate cut, usually on the basis of growth pessimism. It does not in itself make a slowdown more likely.
This perspective has 2 important implications:
1) The markets’ current beliefs and perceptions of risk can be fickle and wrong!
Government bond markets can, and usually do, reflect rate expectations, but they can also be manifestations of the experience of ownership. Despite some arguments that bond markets are composed of more rational investors (rather than just having lower pricing model uncertainty) they are not immune to emotive sentiment, particularly when they have just gone up strongly with low volatility:
Such sentiment can cause a shift in valuations, without regard to underlying fundamentals. We believe that the impact of the experience of ownership and its influence on risk perceptions is an important mechanism in asset price determination, and frequently a source of opportunity.
Moreover, even if market prices are more about expectations for fundamentals than emotional forces, that doesn’t mean these beliefs are correct either; consider how wrong the consensus on Treasuries has been this year. When changes in fundamental expectations are dramatic and rapid there is a good chance that they are not well-calibrated. Human beings are prone to making errors.
2) You can’t make money out of observing indicators like the yield curve unless you’re willing to say something different about them.
And even if prices accurately reflect probabilities around fundamentals then observing on them still shouldn’t help us make money anyway.
If the inversion of the yield curve is indeed a perception of increased recession risk (as seems likely) then we may feel worried about the warning signal from the bond market, but it would only be indicating that everybody else is feeling worried as well.
It is highly unlikely that these fears would not be reflected in the pricing of other asset classes (they don’t operate in a vacuum) and unless we’re prepared to be more or less worried than the market is we don’t have an investable insight. Simply highlighting said “warning signal” doesn’t really help anybody.
So markets aren’t clairvoyant. They absolutely may “tell us things”, but it’s important to remember that we as the market set prices, not some omniscient power. They’re telling us about how we think and feel about owning assets and what we think may come to pass. Not what will.
But nor are markets stupid. While we’re evidently tempted to defer to markets for insight (especially perhaps if it confirms our underlying biases), it’s interesting how willing we can also be to then treat them as naïve and easily fooled. People are quick to identify “what the market doesn’t get” or “what the market is missing” and this language too should be treated with caution. While on the one hand we hear about what bond market pricing is telling us, regarding risk assets we hear headlines like “The stock market can’t be entirely brain dead, right?” or “Investors are ignoring mounting evidence of major global risks and sending stocks in to record territory.”
Us humans are prone to overconfidence in our own intelligence and abilities, but the reality is that many intelligent and able individuals are all analysing the same problem and we need to focus clearly on how realistic it is that they’ve collectively failed to spot or understand the implications of an issue that we can clearly identify. Most important of all, if we find ourselves thinking that the market is all-knowing in one respect, and deeply foolish in another, it is likely that we need to examine our own biases to understand why we think this way.
Squaring the circle
The rally in both bonds and equity markets that has characterised the start of this year has caused a great deal of surprise, even among central bankers. The below from the governor of the RBA is perhaps the best illustration of a common view:
The reality is that there is no inconsistency in bonds and equities rallying together. We have spoken at length on this blog on the correlating nature of rates and the impact this has had on the diversification and returns of multi asset strategies.
Risk assets, and equities in particular, are considered as long duration assets (income streams are some way in the future). It need not be a case that risk assets are naively ignoring impending negative economic outcomes, but simply the fact that the impact of decline in the global discount rate outweighs declining growth expectations. The Treasury market in the US clearly reflects this global discount rate, impacting the pricing of all other assets. The market’s view of the trajectory of interest rates changed direction this year, even before talk of more QE out of Europe, and (coupled with a greater degree of comfort in owning fixed income) has contributed to a rallying bond market. Meanwhile, the removal of a fear of the rising discount rates that pressured asset valuations in 2018 is entirely consistent with rallying equity (and other risk) markets. This is particularly true given the starting valuations of equities entering 2019!
When market moves seem confusing or stupid, it is often our analysis that is flawed. Investment decision making ultimately relies on disagreeing with the market pricing of assets, but we need to be careful in our willingness to pick these quarrels and clear in identifying why we think such an opportunity might be available to us. It’s a difficult activity to engage in and shouldn’t be taken lightly. Markets aren’t omniscient and they can make mistakes, but they also aren’t stupid or easily beaten.