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The ignorance of markets

The ignorance of markets

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There is considerable debate about whether markets are efficient, and whether investors are rational. To me it is self-evident that investors at times are anything but rational and markets at times are anything but efficient, but I will leave the economists to argue about that. If anyone really wants to know more about the limitations of the efficient markets hypothesis, read this post by Euronomist. And for more on whether or not human beings really are rational utility maximisers - as is implied by the rational expectations hypothesis - read this post by John Aziz.

When it comes to monetary policy, though, all too often we are not dealing with inefficiency or irrationalilty, but simple ignorance. In an interview on Reuters TV recently, Ashraf Laidi, Chief Strategist of City Index, a leading FX trading company, said this about the UK's monetary policy:

"But bond traders will continue to push yields higher as long as the Bank of England shows reluctance to taper these asset purchases. That's something that has not even been mentioned about the UK. So probably we need to start looking into when the Bank of England is going to reduce its £375bn of monthly purchases. These have to be reduced some time before we talk about higher rates."

Now there are a couple of very obvious errors in this. The Bank of England is not currently doing QE: the size of asset purchases has remained at £375bn now for nearly a year. So we are not talking about "tapering" in the US sense, i.e. gradually reducing the size of monthly asset purchases. There are no monthly asset purchases in the UK. Indeed there never have been: UK QE was never done on a regular monthly basis. It seems the Chief Strategist has got his countries mixed up.

What Laidi means by "tapering" in this case is reducing the size of the Bank of England's balance sheet by selling assets and draining excess reserves. That is a very different matter from the situation in the Fed, where "tapering" would simply reduce the rate of expansion of the Fed's balance sheet. The Bank of England's balance sheet is not currently expanding - indeed it will soon start shrinking naturally as its stock of assets matures, unless the Bank makes more purchases to replace those that mature.

But Laidi's assertion that the Bank of England's £375bn stock of assets must be reduced before we can even talk about rate rises is simply wrong. The fact is that the Bank of England does not have to sell its assets before raising rates. Laidi's assertion is contradicted outright by Mark Carney, the Bank of England's Governor, on p.20 of his written evidence to the Treasury Select Committee (my emphasis):

"To ensure the MPC retains adequate room to respond to developments in economic conditions, it will be sensible for any tightening in monetary conditions to come about first through an increase in Bank Rate that could, if necessary, be reversed easily. In systems like the Bank of England’s, in which reserves at the central bank are remunerated, there is no obstacle to raising short-term interest rates before the size of the central bank’s balance sheet is reduced." 

Carney subsequently confirmed this in his interview with the Treasury Select Committee on 12th September 2013, stating categorically that "the rate rise would come first".

Carney's observation that remuneration of central bank reserves enables exit from QE without reducing the size of asset purchases is important, because it gives an indication of the Bank of England's likely exit strategy. To return to using the base lending rate as the primary monetary policy instrument, excess reserves have to be drained from the financial system, but that doesn't necessarily mean that assets have to be sold. As Peter Stella points out in this excellent article at Vox, Peter Stella, raising interest rates is itself a QE exit strategy:

"Central banks to exit by raising interest rates, not by shrinking balance sheets".

Stella then goes on to discuss a number of ways in which the Fed could exit from QE without selling assets. Although the Bank of England's monetary policy framework works slightly differently from the Fed's, in that the Bank explicitly sets the base rate rather than influencing a funding rate via open market operations, Stella's strategies would also be appropriate in the UK. Carney's remark suggests that he is considering raising the interest rate on reserves in order to pull the base rate upwards. Stella notes that this approach is not without its problems - although the Bank of England would not be concerned about having the main policy rate set by fiat, since that is in effect what it already does anyway. Nonetheless, in due course the Bank of England will probably also consider term deposits and reverse repos as alternative ways of draining reserves without selling assets. And as Shaun Richards suggests, it may also allow part of its asset stock to mature naturally, though that would take some years. Personally I doubt if either the Fed or the Bank of England has the slightest intention of significantly reducing their asset holdings even after rates start to rise. They are much too useful as instruments of monetary policy.

I suppose it is possible that bond traders are pricing in asset sales ahead of rate rises, as Laidi suggests: that would explain why yields are rising in apparent defiance of the Bank of England's forward guidance. But really this makes no sense. Pushing yields up could actually encourage the Bank of England to do more purchases to force them down again. So either our bond traders are ignorant, thinking asset sales will happen before rates are raised and pricing accordingly: or they know that rate rises are not dependent on asset sales and won't happen any time soon anyway, but are forcing up yields because they want the Bank to do more purchases. Frankly I hope it is the latter: ignorant bond traders are far more dangerous than those who know what they are doing. But I fear it is the former. If Laidi can get this so wrong, how many other traders and strategists are there who also haven't bothered to find out what QE exit is likely to look like?

I am pretty appalled that a senior strategist apparently knows so little about the workings of monetary policy, given the influence that central banks have on markets (and vice versa). And I wish I could be confident that Laidi is the only one. But he isn't.

The following day, also on Reuters TV, Peter Shaffrik, Head of European Rates Strategy at RBC Capital Markets, completely failed to understand Carney's remark to the Treasury Select Committee that "under the right circumstances" a steeper yield curve implies looser monetary policy:

"Not too long ago we have been told it's a very good thing that asset purchases (QE) has helped keep the long end rates down. Now a steep yield curve even with very short front end rates obviously implies higher long end rates. And that's a bit contradictory".

If Shaffrik had listened to the next part of Carney's evidence he would have heard the explanation for this apparent contradiction. But it doesn't take a great deal of imagination to work it out. It all depends what behaviour you are trying to influence with monetary policy. If the aim is to discourage saving and encourage spending - to bring forward consumption to the present - then depressing long-term rates makes sense. But if what you are trying to do is encourage lending for investment in longer-term projects, then steepening the yield curve does indeed constitute looser monetary policy. Lenders engage in maturity transformation - they borrow short and lend long. Depressing short rates and steepening the yield curve reduces funding costs and improves returns on longer-term lending, which should encourage banks and other financial institutions to lend. As a major cause of the slow recovery has been a massive failure of private investment (and public, but that's another story), it makes complete sense for Carney to address that by adopting a policy that flattens the short end of the yield curve and steepens it beyond 2 years:



(source: FT)

To me, the behaviour of markets in relation to monetary policy suggests that most traders and strategists haven't a clue how it works. They base their strategies on irrational assumptions formed from prior beliefs, many of which are known to be wrong - such as the widespread expectation that QE will increase inflation when there is not a shred of evidence that it has ever created significant inflation in any country where it has been used for any length of time; the irrational belief that excess reserves necessarily lead to more bank credit, when the fact is that banks cannot and do not lend out reserves; and the equally irrational belief that rising bond yields are always a bad sign for an economy, when for developed economies in a slump rising bond yields can actually indicate that economic prospects are improving. This last is particularly irritating, because trading strategists of all people really should understand the pro-cyclical nature of bond investments. People invest in bonds when they have little confidence and are therefore risk averse. QE leans against this tendency by reducing the yields on bonds to encourage investors to diversify into riskier assets. And it has achieved this, but unfortunately the result has not been increased domestic investment: instead the money has gone into emerging markets. Hence Carney's change of strategy.

The ignorance of markets regarding QE and interest rate policy is particularly galling because central banks have produced numerous papers on QE and its exit, as have institutions such as the IMF and the BIS. And the effects of QE and strategies for exit have been extensively discussed in the economics blogosphere, where much of the really good research and analysis into the effects of monetary policy is to be found - from Interfluidity and Scott Fullwiler, for example, plus of course FT Alphaville's excellent posts. So strategists have had plenty of opportunity to find out what the effects of QE and ZIRP really are and develop informed views as to what a credible exit strategy might look like. That they don't appear to have done so is frankly inexcusable. The argument that monetary policy is "difficult to understand" simply won't do. These people design trading strategies and shape markets. It is their job to get it right - and in these days of central bank dominance, that involves taking the time and trouble to understand how the monetary system really works and in what ways monetary policy influences markets. And they are paid a lot of money to do this. If the comments from Laidi and Shaffrik are representative of market strategists' views, I frankly wonder whether they really earn their keep. In market making, ignorance is incompetence.


Related reading:

FT Alphaville's numerous posts on QE

Numerous papers on QE from the IMFBISNY Fed and St. Louis Fed, among others.

QE myths and the Expectations Fairy - Frances Coppola (Coppola Comment)

The QE Debate at Coppola Comment.

So you start to follow the money - Barnejek

Video links:

Treasury Select Committee 12 September 2013 - Parliament Live (over 2 hours long - stiff brandy recommended! Sound missing for first 4 minutes)


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Hey Francis,
If bond traders are wrong and you know what is right then put your money where your mouth is and place a bet. You seem pretty confident that you know what you are doing.
James

"The people I criticise in this post are apparently not even "cognizant" of the actions of central banks and institutional players. I would not criticise people who, while understanding the actions of central banks, deliberately chose courses of action that did not take them into account for genuine reasons of risk and profitability. "

I think this is fair. It isn't that certain traders deliberately chose a course of action that does not take them into account, it is that a trader who is aware of larger market participants understands that their actions will manifest themselves in the price changes in each moment. By reacting to such price changes while managing downside risk, a trader can be quite profitable while trading along with such powerful institutions.

"I am criticising people who make trading decisions on the basis of wrong beliefs about the effects of monetary policy, because they have not bothered to inform themselves."

Agreed. I'd think that such erroneous views would eventually lead them to losses which would force them to adjust their mental model of how the world functions otherwise they risk huge loses. What I don't find acceptable is when such views are made public while going unchallenged especially when evidence and discussion within the econ community has already falsified such views.

I also want to stress the point that just because someone is a profitable trader/investor doesn't mean the the market participant has put in the time learning monetary policy. The reason I stress this is because certain famed investors/traders have openly discussed monetary policy as if they were authorities on the topic when certain things they say have already been refuted.

Frances Coppola

Arthur,

My version of "anyone" is the same as it was throughout this post - market players.

For my views on the rest of your comment, please read my longer response to Rafael Barbieri.

Frances Coppola

Rafael,

The world changed after Lehman. I don't think markets have caught up yet. The reality is that central banks now play a far bigger role in markets than they did prior to Lehman, and predicting and/or responding to their signals is now far more important. Ignorance of the behaviour and motivations of central banks may not have mattered much in the past, but it does now.

The people I criticise in this post are apparently not even "cognizant" of the actions of central banks and institutional players. I would not criticise people who, while understanding the actions of central banks, deliberately chose courses of action that did not take them into account for genuine reasons of risk and profitability. I might think they are playing with fire, but at least they would be doing so from an informed and rational perspective. I am criticising people who make trading decisions on the basis of wrong beliefs about the effects of monetary policy, because they have not bothered to inform themselves. It really isn't good enough to say that provided the customers are equally ignorant, ignorance doesn't matter. In the central bank-dominant world we now occupy, that approach will eventually lead to failures.

It's difficult to figure all this out. Very curious to hear your take on John Hussman's recent comment:
" Of course, the Fed might also be able to raise interest rates a quarter of one percent by paying roughly $9 billion a year to major banks, as incentive to hold reserves idle – paying banks an additional $9 billion annually as interest on reserves for each quarter-point hike in rates thereafter – but this will fly with the public for something like ten minutes once it goes beyond a fraction of a percent. The prospect of paying banks to hold idle reserves is particularly challenging given that the Fed is already likely insolvent, having blown through the bottom of its balance sheet with a portfolio leveraged 60-to-1 against even its stated capital, quietly wiping out that capital as long-term interest rates have surged well above the weighted-average yield at which those positions were established. The larger the Fed’s balance sheet becomes, the greater the risk that public scrutiny will demand a reduction in the Fed’s independence. "

Regards

"You surely aren't suggesting that understanding the strategies and motivations of (these days) the largest players in the market is not the job of trading strategists?"

It is one thing to be cognizant of the actions of central banks and large institutional players, it is another to come to trading decisions based on such perceptions. There are many trading style that are reactive to changes in price while adhering to sound risk management that have absolutely nothing to do with macroeconomics. Actually having an opinion can be a determinant if it results in the trader not following their trading strategy fully.

Imagine a situation where a person is making a buy or sell decision based on their macro conclusions. Their position starts producing a loss as price has moved against them. What are they to do if they fully believe their position is 'correct' in a macro sense? Should they cut their loss and exit the position? What if they eventually realize that their macro views have been wrong after much time has based and losses have mounted?

So I think it is absolutely incorrect to state that the only way to make money in today's market is to understand what central banks are up to and predict the price movements. I personally know of people who know nearly nothing about monetary policy and are very profitable. Actually, it can be quite annoying when very successful individuals start expounding about macro policy just because they have had trading success when they know full well that their trading style has nothing to do with understanding macro.

So its very possible for actual traders to be incompetent when it comes to understanding monetary policy, and this will continue as long as they are profitable.

My point is that in a world of hyper-liquidity and imprecise risk transmission....then 'incompetence' is no barrier to profitability as long as there is sufficient 'churn' from one's customer base......

Further, I do not accept that 'the only way anyone can make money in today's markets is by understanding what central banks are up to'.... as calling 'tops' and 'bottoms' is the way of the 'pig'....as opposed to the 'go with the flow' bull/bear traditional market maker approach.

Also, I think that you are conflating 2 separate sections now ....in that your version of 'anyone' may mean 'anyone exposed to market fluctuations through their pension/mutual fund and savings'....and I'm mainly referring to the 'market players' whose incompetence you were originally seeking to excoriate....

Frances Coppola

Arthur,

As the only way anyone can make money in today's markets is by understanding what central banks are up to, predicting their movements and gaming them, for strategists to be ignorant of monetary policy implies incompetence.

It is NOT the job of trading strategists to understand "the strategies and motivations of the largest players". Nor is it their job to have a good understanding of what the current theological flavour of the month is in the field of macroeconomics.

Their job is to make money and 'strategists' do this by inventing plausible hot air that will bring punters to the doors of their institution.

It is a truism that
'in markets, bulls can make money and bears can make money but pigs get slaughtered'....

and anyone who has spent more than 5 minutes in the company of traders, market makers and brokers ....(as opposed to the risk managers, strategists, analysts and other commentators ) will understand that most of them do not have an understanding and actively avoid trying to have one...so that they may concentrate on coping with and reacting to price changes....

The world of markets is not deterministic, it is adaptive...so there cannot be a 'grand unified theory' that makes sense of it all.

Yes, there are incompetents and fools and charlatans in our financial markets. It is precisely because everything is in flux in markets and that markets only repeat themselves outside of an individual's memory/experience that it is almost impossible to eliminate these people from participating in and abusing our markets.

Frances Coppola

Rafael,

You surely aren't suggesting that understanding the strategies and motivations of (these days) the largest players in the market is not the job of trading strategists?

In modern 'big data' terms there are no such things as markets, aggregates or averages. We are still not thinking in the new terms. I find it hard to believe QE was anything other than further subsidy of the banks intended to allow them further speculation to regroup and hide losses in the hope an upturn would cover the 'investment' through new profits. Wikipedia is somewhat more reliable on QE than the experts Frances has caught out.

Big data approaches - for a hopeful summary see http://www.edge.org/conversation/reinventing-society-in-the-wake-of-big-data - should let us organise a global turn to green energy by understanding the connections in our economies that are in the way. At the moment we pull 'levers' like QE with apparent consideration of macro models - but these may be flim-flam models through which to present policy to the uneducated or miseducated public. The real policy may well be just to make the rich richer - the undoubted result.

We know it is possible to be very clever and deeply incompetent. There are big questions about the people in the economic-political circus. In the post-92 rip-off of the former Soviet Block, I often heard the phrase 'the apparatchiks are becoming the entrepreneurchiks' and there are huge numbers of hymn-sheet singers passing themselves off as knowledgeable.
Japan had publicly dismissed QE by 2001 and yet the 'experts' felt able to pass it off to us as an attempt t get investment lending going years later.

I have seen no explanation recently of why direct action in 'going green full employment' is so impossible and very little on just how subsidised the banks are - at least in main media debate. Instead, we have policies that failed Japan.

Great post, but I do have one major contention.

"These people design trading strategies and shape markets. It is their job to get it right."

Doesn't this assume that the goal of a trader is to "price in" a correct interpretation of policy? This may not be so at all. Trading myself and reading an abundance of literature while also speaking to other traders, it becomes obvious that the number one goal of a trader is to be profitable. Therefore, trading strategies that primarily involve asset price movements have very little do with with macroeconomics and have much more to do with profitable trading methodologies and more importantly proper risk management.

Furthermore, traders who do take the time to understand macro issues such as monetary policy may need to trade in a way that looks like they are conforming to potentially erroneous macro interpretations because prices are moving in a way that reinforces the incorrect macro views.

Being contrarian can be quite expensive if asset prices start moving against the trader.

Frances Coppola

Hi Elizabeth,

It's certainly not a silly question. A bond trading strategy could include selling bonds in order to force down the market price. They aren't necessarily dumping long positions - they may be shorting. Some people believe that traders shorting bonds was a major cause of the steep rises in yields in the Eurozone periphery in 2011-12, and the EU therefore banned short selling of bonds from distressed periphery states.

If markets expect asset sales, yields would rise in anticipation of a large increase in supply pushing down the price. My point is that as asset sales do not have to precede rate rises, and the Governor has specifically said that asset sales will not be made until after rates start to rise, Laidi's assertion that bond traders are pricing in asset sales ahead of rate rises is ill-informed and illogical.

However, a steep rise in yields would force the Bank of England to act to bring them down or face loss of credibility, since it has given explicit forward guidance over its expected interest rate path and it doesn't include interest rate rises any time soon. That's why I say markets pricing in asset sales could actually force the Bank to do more purchases.

I would guess that the real reason why yields are rising is because the economy is showing signs of recovery. Did you notice my comment that for developed economies in a slump, rising yields can be an indication that economic prospects are improving? However, markets' optimism may be premature. The Bank of England certainly thinks so: it describes the recent rise in yields as "unwarranted". And I tend to agree with them. Rising yields indicate market expectation of interest rate rises, but until this recovery is well established there is no justification whatsoever for raising rates. We have already had one promising recovery snuffed out....and it is always worth remembering 1937, when the US was forced back into depression by premature monetary tightening.

I want to ask a "silly question". I may not be the only person who does not understand this point, so I may be performing a service to others.
I have no training in economics but I did work in the City for a bank for many years and I always asked questions. I have understood "yield" to mean the true return on an investment, as opposed to its face value, therefore yield became greater when the market value of the investment dropped and less when the the price rose. Putting more bonds into the market presumably reduces the market price as there will be a glut of bonds. That increases the yield. How can a bond trader, ignorant or otherwise, be "forcing up yields because they want the Bank to do more purchases"? Are they dumping their bonds? Or is this just a suggestion of an impossible option - in other words the bond traders are not what is influencing "the way yields are rising in apparent defiance of the B of E's forward guidance". And if not, what is causing the rise?
I have probably missed the point, and I would be grateful for clarification.

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