The Confidence Test
Wednesday may have seen a very important development for the financial markets and, by extension, for the world economy. But before explaining what and why, it is worth stressing that what is important for the markets is not necessarily important for the real economy, and vice versa. There is a widespread tendency to judge countries and regions on the basis of how their stock markets perform – and the most charitable explanation for this is that stock markets provide a quick and easy method to measure what is happening. But what is good for the markets is not the true measure of economic health, at least for ‘the 99%’, i.e. the general public. On the other hand, it is an excellent measure of the wellbeing of ‘the 1%’ – the rich elite who own pretty much everything and seek to tell the sheeple what to think.
Nevertheless, there are times when the markets do reflect the real economy, although these times have become steadily rarer over recent years – and for a very good reason. As the degree of central bank intervention in the financial markets has grown, the ability of those markets to fulfil their basic function of ‘price discovery’ – meaning what a financial asset, such as a company’s shares or a country’s bonds are actually worth – has become increasingly impaired. To put matters plainly: the financial markets are now warped and the prices they generate are increasingly distorted. Since this process of distortion is deliberate, it is not unfair or inaccurate to say that the markets are rigged.
However, since the rigging is being done by central banks and not individual speculators, it is not politically correct or even polite to use words such as ‘rigged’, ‘manipulated’ etc. Central banks are public bodies, key agencies of government which have an added advantage over mere elected politicians, in that they are ‘independent’ and are perceived as repositories of expertise. Thus the policy pursued by central banks since 2008, of massively expanding the quantity of money they pump into their economies – via a combination of ultra-low interest rates and ‘quantitative easing’ (QE) – is seen as both necessary and sensible, mainly because the respected central bankers experts say it is. It is also ‘good’, in a policy sense, because it is aimed at improving the state of the economy by generating faster growth, more employment, and so on.
Which brings us to Wednesday (midday in the US, evening in Europe and here), when the Federal Reserve Bank’s Open Market Committee announced the results of its latest deliberations. The announcement was that the Fed would buy $45 billion-worth of US Treasury bonds and another $40 billion-worth of mortgage-backed securities, every month, during 2013 – a total of almost one trillion dollars. But since this merely extended what the Fed has been doing since September, and the continuation of this program in 2013 had been universally expected, this announcement was not the important event mentioned above.
The other element of the announcement — that the duration of the Fed’s very expansionary monetary policy would henceforth be defined in relation to specific levels of inflation expectations and of unemployment, rather than in terms of time (such as ‘until mid-2014’) – was surprising. The formal adoption of this new approach had been expected only next year. But the substantive shift is also potentially significant, although economists’ views as to how important it is vary widely (as usual).
But the truly important event was what followed: for the first time, the markets failed to respond enthusiastically to the announcement of a new Fed program of QE. After an initial jump up, on a very modest scale compared to previous occasions (80 points in the Dow Industrial index, for example), the markets retraced this and ended the day either flat or down. Once again, although the share market indices attract the most attention, they are not the best indicators of relative importance.
Far more significant, and potentially ominous for both the markets and the real economy in the US and everywhere else, was the fact that Treasury bonds paid no attention to the announcement. Bond prices fell on the day and yields rose – which, in the face of an announcement of continued and expanded purchases of bonds is strange, to say the least.
The mainstream analysts glossed over the tepid and even negative market reaction to Bernanke’s latest move. By contrast, the anti-Establishment bloggers saw it as a signal that the Fed has ‘run out of ammunition’. It has done everything it could think of to stimulate the economy, with very mediocre results, and has nothing left except more of the same – which, given the very weak data relating to the real economy, is clearly not good enough.
Who is right? The answer should not be long in coming. If, over the next days and few weeks, yields on Treasury bonds of 7, ten and thirty years’ duration continue to rise — to 3% and then 3.1% on the 30-year, for example – then a fundamental change has occurred in the markets. This change would signal that confidence in the ability of the Fed and other central banks to push things in the right direction, even artificially, was eroding and would be a grim portent for 2013.