Recently I have been making statements about bond markets of the “markets are saying…” variety, that attribute firm economic insights to the chaos and divergent individual viewpoints that make up our credit markets. As a big believer in the wisdom of crowds I want to explain why.
Back when I was in business school, Michael Mauboussin, who taught a class with a lot of insight on behavioural psychology in markets, became one of my favourite teachers of all time. He was that good. I remember in one of his classes when he paraded a jar of gumballs around. He asked us to each guess how many gumballs were in the jar, and write our guess down on a scrap of paper. Maybe we were supposed to win something if we guessed right. I’ve forgotten now. But after we were done guessing, one of the students collected the scraps and put them in order from smallest to biggest guess.
When all was said and done, as I remember it, the closest guess on the gumballs was the median answer of the class, nearly bang on the actual number. And as Mauboussin explained it – relating the exercise to his lecture, that’s the wisdom of crowds in action. What he was saying was that markets are pretty good at sussing things out. The apparent chaos of any market hides a sort of consensus-building between wildly differing points of views that ends up doing pretty well most of the time.
But of course, there are problems with markets. Mauboussin spent a lot of time on the heuristics or mental short cuts we use to make investment decisions, which get us into trouble. But even as a collective, anchoring and herding and other side affects of our being social animals can cause markets to get things horribly wrong too. We saw this during the housing bubble and during the Telecom, Media, and Technology bubble that preceded it.
So while markets get it mostly right, we have to be careful to deify them as infallible processes. That’s what I’m thinking when I write something like, “the flattening yield curve in government bond markets is telling us secular stagnation will continue.” It’s not that I’m saying individual market actors believe in secular stagnation. Rather, it’s more that, in the US case, the collective view expressed by government bonds markets shows an incredulity regarding the Fed’s ability to raise rates at the pace it says it will raise them.
If the Fed is telling us point blank that it wants to raise rates 3 times in 2017 and 3 more times in 2018 and the 10-year bond yield actually sinks, it suggests that enough people are betting against those hikes all actually happening such that it sways the market decisively.
When I see that kind of market action – essentially fighting the Fed, I take it onboard as, “yeah, usually markets are good at sussing these things out but let’s look and see if markets have it wrong”. And it’s that process of disproving the markets that led me to conclusions like the one in the post on “how monetary policy entrenches secular stagnation”.
When I look to disprove the market consensus, what I see everywhere from a policy perspective are fiscal and monetary policy choices that are expansionary only in relation to the financial economy. When you look at real economy factors, you see people saying “the economy would crash to a very, very low unemployment rate” if we didn’t tighten things up here.
Now I’m sure people like Bill Dudley at the Fed think that they are being cautious in slowly reducing monetary stimulus. Yet, when you look at how markets are positioned, it’s clear that a lot of people see continued low growth for years to come – a veritable Japanification of the US economy.
I hope this is one of those times that markets are wrong. But I am not willing to bet on the hope, just the opposite.