Anatomy of a Confused Market

Cameron sent me this valuable data, which I will use to analyze the market reaction to Tuesday’s Fed announcement:

The S&P :

Zoom in on 5 day or 1 day and you’ll get even better than 15-30 minute intervals.

I can’t find yields yet, but here are prices:

2 Year Treasury Prices
5 Year Treasury Prices
10 Year Treasury Prices

Here’s the graph for the S&P 500:

If you click on Cameron’s link, a bouncing ball will announce the exact time.  As I see it, stocks were 1135 at 2:15, fell to a low of 1104 at 2:42, and rose to a peak of 1172 at closing.  Then the next day they opened down around 1140.  Here’s how Andy Harless described the stock market reaction to the Fed announcement:

At the close on Tuesday (by the time it finished parsing the Fed’s statement), the stock market was up quite dramatically, with the Fed’s statement as the only reasonable explanation. Meanwhile, at the time the stock market closed (as well as before and after) yields on Treasury securities were considerably lower than they had been at the beginning of the day. Surely these observations are not consistent with the interpretation of falling interest rates as the result of a contractionary shock.

That’s a highly persuasive argument, but I’m going to argue the opposite.  Let’s look at the price of two year notes:

The price seems to have been about 1049.5 at 2:15, rose to a peak of 1051.8 at 2:42 (note the time!!), fell to 1051.1 at 4:00, and opened back up at 1051.6 the next morning.  That’s the exact opposite of the path of the S&P500.  But since bond yields and prices move in the opposite direction, stock prices and interest rates were positively correlated after the Fed announcement.  Here’s my interpretation:

1.  In the first half hour the markets digested the report, and were quite disappointed.  They did note the Fed commitment to hold rates down, and that contributed to the reduction in two year bond yields.  But they had hoped for something better–such as QE3, or at least a strong signal that QE3 was on the way.  This disappointment caused stocks to fall sharply.  If QE3 had occurred, then it’s possible that the economy might have recovered enough to allow fed funds increases before mid-2013.  Now that the Fed had virtually guaranteed no increases until then, two year yields fell from slightly above 0.25%, to slightly below 0.25%.  No big deal for the economy.   But a missed opportunity in the eyes of the market.

2.  I could stop here, and say the EMH predicts that any market response occurs very quickly.  But let’s be honest—the subsequent powerful rally in stocks was probably linked to the announcement.  Some sort of “second thoughts” hit the market.  I’m not exactly sure what those were, but I’ve seen two possibilities discussed.  John McDermott suggested that there was wording similar to the Fed statement that preceded QE2.  Others pointed to the three dissents, suggesting that Bernanke is preparing to move ahead more boldly, and is willing to tolerate a higher number of dissents.  Just to be clear, I’m not claiming to know what caused stocks to rally in the last hour.  And I am fully accepting Harless’s conjecture that the late rally was due to second thoughts about the announcement.  All I am claiming here is that the rally was not due to the Fed’s decision to hold rates down for two years–they clearly knew that at 2:42, when both stocks and T-note yields bottomed out.  Whatever these ”second thoughts” were, they almost certainly were not about interest rates, as interest rates actually rose as the stock market rose after 2:42.

3.  On Tuesday evening there was another flood of commentary, including the eagerly awaited “Epic Fail” post on this blog, which turned Wall Street in a more pessimistic direction.  This caused stocks to open sharply lower, and interest rates to fall as well.  So whichever way the market moved, stocks and bond yields were moving in the same direction.  Andy is right that stocks ended Tuesday higher and bonds yields ended lower.  But there is no evidence that stocks ended higher because bond yields ended lower.  Instead, the late rally in stocks seems to have been due to investors finding other glimmers of hope in the Fed statement.  During the period when the 2 year low interest rate policy was being absorbed and fully processed by the 2 year T-note market, stocks actually fell sharply.

4.  Now let’s look at the graph for 10 year bonds:

Here we see a broadly similar pattern, with one anomaly–which might represent market inefficiency.  The price of 10 year bonds didn’t peak until 3:10.  This means 10 year yields hit bottom at 3:10, 28 minutes after both the S&P500 and 2 year yields bottomed out.  Perhaps traders in the 10 year market were different from those in other markets, and were slower to catch on to the “second thoughts” of traders in the stock market.  Note that even at 3:10 stocks hadn’t risen very much off their lows, and were still well below 2:15pm levels.  However I hesitate to call that “inefficiency,” as even today we don’t know if those second thoughts were correct.

The Fed has picked such a bizarre and convoluted strategy that it is difficult for markets to predict which way the economy will go.  Under interest rate pegging, NGDP can either fall or rise at an accelerating rate, depending on tiny differences in initial conditions.  (Think about those saddle-point graphs you studied in math.)  Fortunately, they only committed to this idiotic policy for two years, and hence it’s unlikely we’ll see explosive moves in either direction.  But it would have been much simpler if the Fed has just TOLD US WHERE IT WANTS TO GO.

Of course my use of bold letters just shows that I don’t understand all the subtle games a political institution like the Fed must play.  Ryan Avent (who wrote the following) and Tyler Cowen have a better understanding of what goes on in Washington, and here’s what they think:

Which is it? Market movements are at least as suggestive of a weak statement as a bold one. I had the opportunity to speak to Tyler Cowen today, and he made a few interesting points by way of judgment. Those looking for a positive, pro-inflation sign in the statement could point to the three dissenters, he noted; clearly enough changed in the report to drive the more hawkish members (whatever the merits of their view) to find the shift objectionable. However, he noted that its ambiguity was suggestive of a Fed facing intense pressure from two sides, and wishing to put itself in a position to avoid blame for failure but take credit for success.

I also think the ambiguity is problematic. It doesn’t much matter if Fed insiders all understand the sly-yet-bold nature of the Fed’s action if the tens of millions of price-setters in the economy don’t get it. If financial markets are acting schizophrenic, it may well be because the Fed has them guessing at two removes. Markets aren’t just weighing what the Fed said; they’re weighing how economic actors will weigh what the Fed said.

Now, maybe that’s a savvy way to try to help without angering pressure groups, but it strikes me as far less likely to prove effective than a more straightforward statement. Look again at what the Fed said:

“The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

Now you tell me: what inflation rate does the Fed want? What rate is it prepared to tolerate? Maybe—hopefully—the Fed’s action was actually an aggressive move to counter economic weakness. The fact that we’re all still able to debate the matter leaves me sceptical that it was.

Me too.  But let me emphasize again that all I do is infer market forecasts.  As of today markets are still quite pessimistic about NGDP growth.  Whether the markets are correct is a different question.

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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