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Monday 30 July 2012

Bad Habits: The Greenspan Put

Mandated Markets

The recent research from the New York Fed indicating the close correlation between the Federal Reserve’s interest rate decisions and the movement of equity markets just prior to its announcements has added fuel to the flickering flames of suspicion that the Fed’s actions are designed to support stockmarkets and the super-rich who rely on them, rather than the wider economy. 

It's just as possible, though, that market participants can now force anyone they want to kowtow to their demands.  It seems that politicians and central bankers are no longer in charge of the economy, but that the market – at least as defined by the demented lore of economic orthodoxy – rules by dint of habit.  Which is not OK, not OK at all.

A Lot of Drift

The research, by David Lucca and Emanuel Moench, entitled The Puzzling Pre-FOMC Announcement Drift, shows that:
“Since 1994, more than 80 percent of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements (which occur only eight times a year)”
Not only does this drift apply to US markets but there’s also evidence of it, albeit in attenuated form, in British, French, German, Swiss, Spanish and Canadian markets.  What this looks like is that markets are anticipating that the Fed will proactively move to support equities, and would seem to provide de-facto evidence for the existence, at least in the minds of traders, of the so-called Greenspan Put.

The Greenspan Put is a reference to the willingness of the Fed under its previous chairman, Alan Greenspan, to cut interest rates in order to stimulate markets.  Invariably when one or another of the various crises attached to economies has struck the Fed has responded by injecting liquidity into markets, causing stocks to rise – a one way bet, according to many commentators, leading to complacency and a lack of proper risk management by investors. 

Moral Hazard, Revisited

The recent research now suggests that markets have been anticipating the Fed’s moves to support them, a clear case of moral hazard, where people feel that they can’t lose by buying stocks because they’ll always be bailed out.  Marcus Miller, Paul Weller and Lei Zhang pointed this out as far back as 2002:
“We point out that the observed risk premium may be reduced by one-sided intervention policy on the part of the Federal Reserve which leads investors into the erroneous belief that they are insured against downside risk. By allowing for partial credibility and state dependent risk aversion, we show that this ‘insurance’ – referred to as the Greenspan put -- is consistent with the observation that implied volatility rises as the market falls”.
If correct these observations suggest an overvaluation of stocks worldwide, based on the (presumably) erroneous belief that the Fed will – or can – always act to bail out investors. Nonetheless this doesn’t equate to some of the wilder acts of irrationality that have also been used to explain market gyrations – it’s not entirely illogical for investors to become habituated to the idea that they’ll always be bailed out.

Bad Habits

The idea that habits are central to economic behavior, and are implicated in the equity premium puzzle (Do Stocks Always Outperform (In the Long Run)?) has a long history, see (for instance): Habit Formation: A Resolution of the Equity Premium Puzzle by George Constantinides. Habits tend to be created by external stimuli, are slow to change and don’t adapt smoothly to new circumstances – they’re sticky, we don’t like changing habits that make our lives easier, even when it turns out that they don’t work anymore.  Buy and hold, anyone?

So the idea is that market participants have become habituated to the Fed’s normal course of action in the event of some market crisis or another – which is currently something that seems to be a permanent state of affairs.  The Fed, on the other hand, may well be right to be nervous about breaking this belief as attempts to deflate the over-exuberant markets at the end of 1999 seem to have contributed to the collapse thereafter.  Perhaps it’s not the markets which are reacting to the Fed, but the Fed to the markets?

This, of course, is extremely scary because it suggests that the free-market – the self-regulating, free-wheeling, ethically blind invisible hand – is driving the behavior of regulators and central bankers, rather than the other way around.  It implies that the combined views – and money – of traders, all committed to a similar world-view of unfettered capitalism, big bonuses and short-termism are capable of forcing governments into acts of virtual self-immolation if they behave in a way which is not aligned with the economic orthodoxy of the times: profit maximisation.

Errant Bailouts

Take, for example, the ongoing crisis in the Eurozone.  Rather than viewing this as an internal crisis caused by wanton debt mismanagement it’s possible to regard it as a largely artificial problem generated by markets which don’t like the responses of European governments.  The orthodox approach, followed by the US and the UK back in 2008, was to bailout their errant financial organizations.  Of course, it was the failure of the US to do this with Lehman Brothers in order to avoid issues of moral hazard that triggered the meltdown in the first place: the market equivalent of an almighty slap to those with the temerity to put morality over profits (see Moral Hazard, But Thanks For All The Fish).

The European approach has, of course, been far less decisive, largely due to the divisions between the various countries and the tortuous bureaucracy at the heart of the union.  The result of this has been a slow turning up of the screw on the recalcitrant governments, through credit rating downgrades and the higher interest rates demanded by borrowers.  The various governments have been dragged kicking and screaming into measures that markets want, and they don’t.  But every time they stare into the abyss they somehow cobble together another bailout which temporarily relieves the market pressure.

While markets may be good at disciplining poor economic policy they can only do it on their own terms, in respect of the financial rules which they follow.  You’ll not find issues of morality or health or the environment in any balance sheet; the markets protect their own interests by enforcing the measures they require in order to meet the only criterion of success they’re interested in – profit.

Junkie Debt Markets

Viewed from this perspective we can see the recent research on market responses to Fed interest rate setting as the closure of a particularly vicious circle. Past decisions to cut interest rates and promote liquidity have caused investors to develop a habit of expecting these behaviors when markets wobble.  Failure to respond to this leads to further falls, in effect punishing the central bankers for their unwillingness to feed the habit.  The reaction to this is to give the junkies what they’re demanding, because a failure to do so will create an even worse mess than we’re already in.

However, regulators and governments do have the means at hand to change this.  They can create rules which make corporations take account of measures other than pure profits.  This will probably lead to lower growth particularly in more mature economies  the kind of situation we looked at in Manifesto for a Low Growth World – but as this is almost certainly inevitable anyway it would be better to address the issue directly than to continue to allow markets to enforce their particular and peculiar morality on increasingly demoralised populaces.

So the markets are not pre-empting the Fed, nor is the Fed driving the markets: the markets are forcing the Fed to respond to its liquidity habit.  Weaning them away from this is going to take leaders with great vision and great determination: so most of us will probably be better off betting on the continuation of the Greenspan Put.

1 comment:

  1. Isn't there a duration mismatch here? At the company level, you can surely observe all kind of silliness in short term (hours or days) price movements around earnings announcements, this makes the situation more fuzzy than it need be, but does not mean that the long term is really disconnected with how the company fares in the real economy.

    Might be the same at the market level, and there may not be that much to conclude on a long term basis out of the price silliness that happens around Fed announcements.

    What could be interesting is perhaps a future post exploring the bias that some people have to make grand theories that explain too much about the world out of too few minor facts. ;-)