Revenge of the Markets
We often think it's a one-way street, that investors or markets react to policy changes. But markets can push back and drive changes to policy. Two examples of this pushback can be seen in October and there may be more to come in the months ahead. We will cover what changes markets may push for and what it might take to prompt those changes.
In October the markets proved once again that they can drive policy reversals.
- After the new U.K. government's decision in September to propose aggressive fiscal stimulus while inflation is very high, markets responded with a rapid drop in the pound and rise in U.K. government bond yields (the 10-year yield more than doubled from 2.0% in August to 4.5% in late September). The resulting turmoil inflicted on pension plans prompted the Bank of England to intervene in the U.K. government bond market and delay plans to start quantitative tightening (QT). Even more importantly, the market forced Prime Minister Truss to abandon the plans as she resigned after a mere 44 days in office.
Wild market swings prompted U.K. policy change
Source: Charles Schwab, Bloomberg data as of 10/23/2022.
- While electricity and natural gas prices in Germany have come down this fall, after soaring this summer as Russia cut off the Nord Stream gas pipeline, they remain historically high. Last week, in a dramatic reversal of an earlier decision by Economy Minister Habeck, German Chancellor Scholz ordered Germany's remaining three nuclear reactors to remain in operation through the winter in an effort to further ease energy prices.
Last week, China delayed the release of its monthly economic data at close to the last minute, perhaps due to concern about market reaction during the Party Congress meeting of policymakers.
There are plenty of examples of policymakers being driven by the markets to reverse policy decisions. The market signals the need for policymakers address a crisis by moving sharply lower. A couple of major examples from recent crises:
- European Debt Crisis - The threat of a Greek exit from the Eurozone—combined with economic stagnation, hesitant reforms, and rising nationalism across Europe—called into question the sustainability of the monetary union. Bond spreads between European countries widened to crisis levels as the market priced in the risk that the Eurozone could break apart. In response, the European Central Bank (ECB), under the leadership of Mario Draghi, pledged to do "whatever it takes." The ECB stepped in with unprecedented bond-buying and monetary-easing programs in July 2012, pulling Europe back together and narrowing spreads dramatically.
Bond market prompted a change in policy in 2012
Source: Charles Schwab, U.S. Department of Treasury, Macrobond data as of 10/21/2022.
- Global Financial Crisis - The Troubled Asset Relief Program (TARP) was formed to address the subprime mortgage crisis in the United States by purchasing assets and equity from financial institutions to strengthen the struggling banking sector. When the TARP program, seen as a bailout, failed to pass the House of Representatives on Monday, September 29, 2008, stock markets reacted dramatically. Investors who had been counting on the rescue plan's passage sent stocks down 9% that day. Two days later, on October 1, the Senate overwhelmingly approved a revised bill and on Friday, October 3, it passed the House and was signed into law by President Bush.
What might the markets drive policymakers to do next? Here are three ideas:
- Japan's currency – Japan's yen has plunged 30% from 115 yen per U.S. dollar in March to 150 in October, hitting a fresh 32-year low. The Bank of Japan's (BoJ) yield curve control (YCC) has kept interest rates capped in a narrow range around zero (+/-0.25%), prompting investors to sell yen and move to higher-yielding bond markets in other currencies. To support the yen without letting interest rates rise, Japan must sell dollars to buy yen. Japan spent almost $20 billion to limit the currency's losses in September which failed to stem the slide. The currency market is trying to compel policymakers to act, but the threshold for forcing action is unclear—with the apparently conflicting policy goals between the BoJ, which is committed to maintaining YCC, and the Ministry of Finance, which is looking to restrain yen depreciation.
Currency market attempting to drive a change in policy
Source: Charles Schwab, Macrobond data as of 10/23/2022.
- Fed rate hikes - The U.S. dollar has risen 18% this year against the currencies of major trading partners as the Federal Reserve continues jumbo rate hikes. Despite the U.S. only accounting for 10% of world trade, around 40% is invoiced in dollars, resulting in higher import costs acting as a further headwind to the already weak outlook for world trade. Higher import prices make inflation outside the U.S. higher than it would otherwise have been. And if other central banks raise policy rates even higher to prevent further currency depreciation, global financial conditions could tighten even more sharply and deepen a global recession. An eventual pivot by Fed policymakers away from aggressive tightening is inevitable, but so far, the moves in the markets have not dramatically tightened financial conditions. Markets have more to do if they intend to strengthen the dollar and weaken capital markets enough to prompt a pivot before inflation comes down more visibly. Fed policymakers have been resistant to reversing rate hikes in the face of market turbulence more than in the past perhaps because the current environment of high inflation is due in part to the Fed not being aggressive enough a year ago to slow its rise.
- Soaring debt – Interest rates have soared. The yield on the global aggregate bond index (which includes government, government-related, and corporate bonds, as well as asset-backed, mortgage-backed, and commercial mortgage-backed securities from developed and emerging markets issuers all over the world) has leapt from 0.8% in July 2020 to 4.0% today. The rising cost of soaring deficits and debt may prompt policymakers in many countries to reconsider their fiscal plans, as was the case in the U.K. in October. Yet, it is unclear where that threshold on rates lies.
Is it a crisis?
While the market moves this year have been dramatic, they have yet to prompt a crisis. In Japan, inflation remains mild (the consumer price index is up 3.0% from a year ago) despite a very weak currency, in the U.S. the rise in the dollar and fall in stocks have not yet dramatically worsened financial conditions, and while there is much more debt outstanding, borrowing rates are still below average pre-Global Financial Crisis levels. Markets are powerful, but change doesn't always come easily. So don't expect immediate policy action, but don't rule out eventual action either. This makes investing a challenge. Markets can worsen until a policy change suddenly prompts a reversal. For investors, diversification and a long-term perspective are key.
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