Markets Really Do Convey What Market Participants Think
Paul Krugman on an underdiscussed point:
And right now, deficit-phobia has quickly congealed into the latest CW. You can see it in editorials (not from the Times, I’m happy to say, but almost everywhere else), in what the talking heads say, even in supposedly objective news reporting. Not a day goes by without my reading some assertion that “markets are anxious/jittery/worried about the deficit” — an assertion based on no evidence whatsoever. (Long-term interest rates on US debt are near historic lows; CDS spreads show no concern about default.)
It’s really maddening that at the same time preposterous idea like strong forms of the Efficient Markets Hypothesis continue to be respectable that people seem unwilling to trust financial markets to accurately convey the beliefs of participants in financial markets. I would add to Krugman’s observations the fact that we have Cato’s Chris Edwards blaming anticipating inflation for the lack of private investment when the TIPS spread shows that markets aren’t anticipating inflation.
Right now economic conditions are bad. And the budget deficit is high. So I find it understandable if the man on the street chooses to conclude that the budget deficit is causing or contributing to the bad economic situation. But people writing about these matters ought to know better—interest rates are low and markets are assessing both default risk and inflation risk as low. So what about the deficit is supposed to be causing the problem? Meanwhile, to repeat myself the wise elected official is going to spend less time worrying about what voters think is to blame for the economic situation than he does on fixing the bad economic situation. Results matter more than folk theories.
39 Responses to “Markets Really Do Convey What Market Participants Think”
Register
RSSLogin
Topic Cloud
ArchivesBlog RollAbout Matt YglesiasContact Me
Donate
November 3rd, 2009 at 1:14 pm
But people writing about these matters ought to know better—interest rates are low and markets are assessing both default risk and inflation risk as low.
A lot of them do know better. What they ought to do is be more honest. (But yes, some of them are simply plain ill-informed on matters of economics).
November 3rd, 2009 at 1:16 pm
It’s really maddening that at the same time preposterous idea like strong forms of the Efficient Markets Hypothesis continue to be respectable that people seem unwilling to trust financial markets to accurately convey the beliefs of participants in financial markets.
So you agree with the Efficient Markets Hypothesis…. or not… or only when it agrees with your policy positions? I don’t understand.
November 3rd, 2009 at 1:22 pm
Like jmo, I find Matt’s rejection of the EMH by name while embracing it in substance to be highly amusing. Of course that is explained by the fact that Matt obviously doesn’t understand what the EMH actually involves.
November 3rd, 2009 at 1:24 pm
So you agree with the Efficient Markets Hypothesis…. or not… or only when it agrees with your policy positions? I don’t understand.
I don’t understand you, jmo. What in MY’s post says or implies anything like this?
November 3rd, 2009 at 1:27 pm
DTM, saying that markets reflect participants’ beliefs ≠ saying that markets yield efficient outcomes.
November 3rd, 2009 at 1:28 pm
when the TIPS spread shows that markets aren’t anticipating inflation
The TIPS spread is NOT a good indicator of market inflation expectations. There is a large difference in liquities between the two types of Treasuries, which makes the spread pretty meaningless.
Paul Krugman certainly knows this but chooses to lie anyway.
November 3rd, 2009 at 1:30 pm
Can anyone find a single case of a credible source backing the strong form of the EMH?
As far as I can tell, it is weak EMH that is basically academic consensus.
November 3rd, 2009 at 1:30 pm
@jmo, DTM,
What Matt and Krugman said (since you didn’t seem to read the post) is that commentators are being either hypocritical or stupid to sing the praises of the Efficient Markets Hypothesis and over the same period to ignore market interest rates.
That’s all he said. Punto.
You are likewise either breathtakingly obtuse or (more likely) craven liars — e.g. Republicans — to assert otherwise.
November 3rd, 2009 at 1:32 pm
@Al:
Can you explain this? Why is a 10-year inflation-proof treasury bill substantially more or less liquid than a 10-year non-inflation-proof treasury bill?
November 3rd, 2009 at 1:34 pm
So WHO has Obama punished for CAUSING this bad economic situation? Who has he criticized? No one. Nada.
WHAT has he done to fix the situation? Nothing
IF Obama doesn’t think anyone else is to blame, then that pretty much leaves Obama.
Which makes sense only if Obama is a collaborator with the Republicans –NOT a competitor. Working for the same plutocrats.
NOT criticizing the Republicans because his Masters are planning on bringing the Republicans back into power in a year or so to fuck us yet once again after the popular anger has died down a little and the voters no longer needed to be soothed with a false illusion of “Change”.
November 3rd, 2009 at 1:38 pm
DTM, saying that markets reflect participants’ beliefs ≠ saying that markets yield efficient outcomes.
And saying that markets yield efficient outcomes ≠ the Efficient Markets Hypothesis.
What Matt and Krugman said (since you didn’t seem to read the post) is that commentators are being either hypocritical or stupid to sing the praises of the Efficient Markets Hypothesis and over the same period to ignore market interest rates.
Krugman said nothing of the kind in the linked post. And I interpret Matt as actually endorsing using market-based approaches to estimating inflation expectations, not just setting up some hypocrisy claim.
November 3rd, 2009 at 1:39 pm
I find it understandable if the man on the street chooses to conclude that the budget deficit is causing or contributing to the bad economic situation.
In my experience, that’s not what the man on the street thinks. The man on the street thinks that running a big deficit means that the country has gone broke and is now in deep deep debt to our new Chinese overlords. It’s contributing to the bad economic situation only in that we spend $300 billion in interest every year. (Never mind where we got that $300 billion from.)
November 3rd, 2009 at 1:40 pm
Can you explain this? Why is a 10-year inflation-proof treasury bill substantially more or less liquid than a 10-year non-inflation-proof treasury bill?
Yes, the TIPS market is signficantly less liquid that the market for regular treasuries. And it has particularly true in the past year. So much so, in fact, that the Cleveland Fed discontinued their forecast of inflation expectations based on TIPS spread.
November 3rd, 2009 at 1:42 pm
The TIPS spread is NOT a good indicator of market inflation expectations. There is a large difference in liquities between the two types of Treasuries, which makes the spread pretty meaningless.
Nonsense. Liquidity issues, the inflation risk insurance premium, and so forth are secondary issues when pricing TIPS. Accordingly, while it is true that the TIPS/nominal spread is not a perfectly accurate indicator of current inflation expectations, it is a decent indicator within a relatively small margin.
November 3rd, 2009 at 1:42 pm
The man on the street thinks that running a big deficit means that the country has gone broke and is now in deep deep debt to our new Chinese overlords.
The only way the Chinese can be “paid back” is if we were to run a large current accoutns surplus with China. Chinese policy makers are never going to allow that to happen. They may one day agree to a balance of trade, but they will never allow us to run a current accounts surplus with them.
November 3rd, 2009 at 1:48 pm
The full linked statement from the Cleveland Fed:
The Cleveland Fed decided to temporarily suspend this method of inflation estimation due to the extreme financial market conditions of last October, which they thought were rendering their normal liquidity adjustments less accurate. That is a defensible decision. But that doesn’t imply that liquidity issues make this a “meaningless” indicator in general, as Al is claiming.
November 3rd, 2009 at 1:48 pm
KC Fed study concluding that (at that time) the difference in liquidities of the two securities “has kept the yield difference from becoming a good measure of expected inflation”.
Again, as noted by the WSJ article above, the liquidity difference between the two markets now is signficant.
November 3rd, 2009 at 1:49 pm
But that doesn’t imply that liquidity issues make this a “meaningless” indicator in general, as Al is claiming.
Right. It could be meaningful – if the liquidity in the two markets allow it. Which is just not the case right now.
November 3rd, 2009 at 1:57 pm
KC Fed study concluding that (at that time) the difference in liquidities of the two securities “has kept the yield difference from becoming a good measure of expected inflation”.
“At that time” was 2001, just four years after TIPS were introduced. As they acknowledged in their paper, this method was likely to become more accurate over time. And that is what everyone thinks happened since then.
It could be meaningful – if the liquidity in the two markets allow it. Which is just not the case right now.
Again, that is pure nonsense. If you want to argue that right now the spread is still less accurate than usual due to liquidity issues, then maybe you have a case (although I would suggest that things have settled a lot since last October). But calling it meaningless is just silly.
November 3rd, 2009 at 2:02 pm
If the TIPS spread were a meaningful indicator of inflation expectations right now, the Cleveland Fed would have resumed their calculation of inflation expectations based on the spread. They haven’t, which should give you a pretty good idea that the liquidity issues are just to problematic right now.
November 3rd, 2009 at 2:02 pm
And saying that markets yield efficient outcomes ≠ the Efficient Markets Hypothesis.
And irrational beliefs ≠ known information.
November 3rd, 2009 at 2:12 pm
Note, BTW, that the reason that the Cleveland Fed discontinued its measure of inflation expectations based on TIPS is that they acknowledge that measure must be adjusted for differences in liquidity of the markets (i.e., you can’t just subtract the nominal treasury yield from TIPS, as Krugman does). They thought that, under normal circumstances, they were able to make that adjustment. But normal circumstances abandoned us a year ago, and have not yet returned to normal sufficiently to make the spread a meaningul indicator of inflation expectations (even given the liquidity adjustment the Cleveland Fed uses).
Note that, the nominal size of the Treasury market is more than 10x larger than the TIPS market. And that is not even accounting for the fact that the TIPS market is much more dominated by buy-and-hold investors (which, of course, reduces the market’s liquidity).
November 3rd, 2009 at 2:15 pm
If the TIPS spread were a meaningful indicator of inflation expectations right now, the Cleveland Fed would have resumed their calculation of inflation expectations based on the spread.
Wrong. The Cleveland Fed was adjusting for liquidity to get what they hoped was a particularly accurate measure, and as I noted above they suspended it because they didn’t think their normal liquidity adjustments were suitable last October. So the fact that they haven’t resumed that program at most implies that they still don’t think their normal adjustments are suitable, not that the result would be “meaningless”.
And in general that is a crappy form of inference: they could have many different reasons for not doing something, and this is only one of the many possible explanations.
November 3rd, 2009 at 2:24 pm
Note, BTW, that the reason that the Cleveland Fed discontinued its measure of inflation expectations based on TIPS is that they acknowledge that measure must be adjusted for differences in liquidity of the markets
I acknowledged it too. Again, though, liquidity is a secondary issue when it comes to TIPS pricing, and what you are arguing instead is that it renders the whole approach meaningless, which is pure nonsense.
But normal circumstances abandoned us a year ago, and have not yet returned to normal sufficiently to make the spread a meaningul indicator of inflation expectations
More pure nonsense. If you want to argue the spread is a little less accurate than usual right now, then OK. “Meaningless”? That is just silly.
Note that, the nominal size of the Treasury market is more than 10x larger than the TIPS market. And that is not even accounting for the fact that the TIPS market is much more dominated by buy-and-hold investors (which, of course, reduces the market’s liquidity).
This is just a collection of bad logic. You don’t need a market as large as the U.S. nominal treasuries market to get a liquid market. Similarly you don’t need every security to be marketed frequently to get a liquid market.
Again, there is a small effect from liquidity issues. But there is no way it is large enough right now to make the spread “meaningless”. That was and remains a silly claim.
November 3rd, 2009 at 2:27 pm
How does China become our “overlord” by holding 7% of US public debt? That’s less than state governments and mutual funds put together, which BTW get a bigger share of those interest payments than any sovereign entity.
November 3rd, 2009 at 2:28 pm
And irrational beliefs ≠ known information.
Well, you can have information about irrational beliefs, but you are in fact getting to one of the legitimate issues in the EMH debate (whether or not people with irrational beliefs are actually setting the prices in the relevant markets).
I strongly suspect, however, that we just left Matt behind, and that he continues to believe the EMH is about efficient outcomes (or something like that).
November 3rd, 2009 at 2:28 pm
The government deficit is not a problem. Hell, it hardly registers in the grand scheme. In fact, it is almost impossible to factor it in to any equation at all.
Total US public and private debt stands at around $55 trillion. US unfunded liabilities exist somewhere between $50 and $70 trillion range. And the US Government is exposed, really exposed, to Wall Street liabilities. There is no accounting for what that total might be should things go haywire. $10 trillion? $100 trillion? Those five big whimsical banks on Manhattan own us. If they go under…eeek!
So let’s say we are buried under a mountain of trouble roughly equaling $150 trillion dollars, give or take $10 or $20 trillion. US GDP, at 14 trillion, is dwarfed by this mountain. And our yearly budget of around $2.7 trillion, is dwarfed by the dwarf.
Congress, specifically deficit hawks, are, by definition, dwarfed by the dwarf of the dwarf. They couldn’t be any smaller if they were one of the little peanuts they battle over.
And yet, somehow, those stupid motherfuckers LOOM LARGE, don’t they.
November 3rd, 2009 at 2:30 pm
Assertions about the psychology of the market are on par with astrology. The fact that anyone pays them any attention is bewildering.
November 3rd, 2009 at 2:39 pm
How about the entire quote rather than cherry picking one word?
So we also have, higher taxes, healthcare mandates, labor regulation and other profit killers listed along with inflation. C’mon Yglesias picking one reason out of four is just dishonest. I suspect it’s because you know he’s right about all the uncertainty Obama has created, all of it anti business.
November 3rd, 2009 at 3:16 pm
That is speculation, but I haven’t heard a better explanation of the death of private investment in America.
That is really one of the most ludicrous things I have seen written lately (and I am including Al’s posts in that comparison, so that is saying a lot). The news is full of perfectly straightforward economic reasons for people to reduce private investment, and as many have demonstrated at this point, private investment went into decline long before Obama was elected. So that is neither the best nor even a particularly plausible explanation.
November 3rd, 2009 at 3:44 pm
The problem with using the interest rate on treasury securities as a proxy for the “market’s” inflation expectations is that you now have a very substantial participation of purchases for non-economic reasons. Foreign central banks and the fed hold about 2.5 trillion in treasuries. http://www.xe.com/news/2009-10-22%2016:45:00.0/754061.htm?c=5&t=107
They are not holding them for investment purposes but expressly to influence interest rates and exchange rates. Moreover, you have banks holding in excess of 1 trillion in treasury debt. For them, they can borrow from the fed at nearly zero and put that money into the treasury market and earn a risk free return. Something not possible for the market as a whole.
So to look at the treasury market for confirmation that the market is not concerned about inflation, when that market is explicitly a vehicle for central banks to suppress interest rates to stimulate the economy is misguided.
November 3rd, 2009 at 3:48 pm
DTM wins the thread.
November 3rd, 2009 at 4:12 pm
Matt says:
“But people writing about these matters ought to know better—interest rates are low and markets are assessing both default risk and inflation risk as low. So what about the deficit is supposed to be causing the problem? “
Markets aren’t very good at predicting inflation and are downright horrendous at predicting defaults. Look at the data. Markets weren’t predicting a cascade of defaults prior to the collapse of Bear Stearns. Yet, that’s exactly what would have happened had not the US taxpayer stepped in to protect Wall Street from the consequences of their actions.
What does all this mean? My I suggest the street has learned one and only one lesson from the experiences of the last twelve months. That lesson is, they can count on the fed to bail them out if/when they get in trouble. The fed has interest rates at effectively zero. There is no doubt that interest rates will eventually have to rise. When they do, the risk that Wall Street unloaded on the GSE’s, the fed SIV’s like One Maiden Lane, will be exposed. The real problem is our once stable currency. If the holders of US Treasuries ever realize their risk exposure is extremely underpriced, the fed will have to raise rates quickly and to levels not seen in several decades. In truth, the street is playing the US taxpayers for suckers. They will earn billions this year and not a penny of that money is ever going to be clawed back when the sh*t hits the fan.
November 3rd, 2009 at 4:22 pm
The assertion that “markets are anxious/jittery/worried about the deficit” is silly on two counts. The first and most important is that ‘markets’ don’t have anything to do with the economy or the news or any subset of the news like the deficit. That is the most important thing but for silliness it is pretty difficult to take seriously the idea that the “markets” are worried about anything after one of the histories great bull runs off the March bottom.
As a practical matter for over 25 years deficits have been good for the markets because they are an expansion of credit. The be all and end all of the financial system. There is not a big time speculator in the entire world who doesn’t want Uncle Sam to run huge deficits. It’s their lifes blood. Some may scold about them but only to the extent the money is going to little people which is just about everyone, but them. Such scolding, while their fingers are crossed behind their backs gives them political cred, with the little people who don’t know they are peasants.
Auction asset markets rise and fall on the amount of money available to them. More money into the markets they rise. It is simple as that. Now the nature of Treasury borrowing within that is complex but for 25 years in the broadest sense that borrowing has helped to liquefy the markets. The question the new deficit scolds like me have is if this relationship is sustainable and we answer no.
In any case every time you hear the market did this today because……… throw a sipper at the TV and utter expletives of your choice.
November 3rd, 2009 at 4:37 pm
Tomorrow in one of the great rituals of the age the Fed will deliver words to the people. Words from on high. Words of the gods. The priests of finance will explore the words for hints and portents of the future. Did this word change from the last time words came down from the temple? What does that mean?
In the vast majority of days when the sacred words are handed down they are greeted with joy. The markets rise to substantiate the greatness of our gods. Coincident with open market operations and providing liquidity to the primary dealers, the gods associates.
Tomorrows word will be examined under microscopes to divine if the gods intend to withdraw or tighten liquidity over the coming months. Never mind that such is impossible even the thought of it makes men tremble in fear. Better to be rendered to Syria than the Fed shrinking it’s balance sheet. Well that is shrinking anyway but not on purpose so the fools can ignore it.
November 3rd, 2009 at 9:20 pm
Re: The TIPS spread is NOT a good indicator of market inflation expectations.
Translation: Facts do not fit Al’s idelogical prejudice, so down with the facts!
Re: The real problem is our once stable currency.
For my entire adult life the US dollar has bounced around all over the place. At least in recent years it has not been “stable”.
November 3rd, 2009 at 9:33 pm
Those emh posts are all odd. Some markets are more efficient, some are less. The cds market is one of the less efficient ones.
A more interesting aproach is to compare interest rates for Eurozone bonds. The liquidity problem also applies here just like with tips, but still much more meaningfull numbers. Take Italy vs Germany.
November 4th, 2009 at 5:29 am
This is assuming people who invest in treasury markets think that TIPS will really track inflation. In reality, asking a government to track inflation is like asking Enron if their books are good, and calling it a day.
Some slaves were beaten with a whip on a daily basis for their entire lives. Useless anecdotes are fucking awesome.
November 4th, 2009 at 8:20 am
The strongest Efficient Market Hypothesis is demonstrably absolutely irrefutable. Are you going to allege macro economic ghosts make people buy things they do not want to buy, or are you going to allege quantum micro economic ghosts make people buy things they do not want to buy?
All trade only occurs because that which is received is valued more than that which is given away in exchange. Trade does not occur when that which is offered in exchange is not valued more than that which is asked to be given in exchange. To argue otherwise is to argue that people want what they do not want, that people do not want what they do want, which is pure contradictory absurd nonsense. QED.