The stock market reaction to the US Federal Reserve's 50 basis points repo rate hike announcement on Wednesday is a teachable moment in the psychology of the markets. I have blogged here earlier.
The US markets reacted by registering its largest one day gain since May 2020 in response to the FOMC decision. This is surprising since the 50 basis points hike is the first in more than 20 years and the Fed also announced two more such hikes before the year end. In particular, the markets appear to have been relieved that a 75 basis points hike is not under consideration as of now.
The US central bank on Wednesday announced its first 0.5 percentage point interest rate rise in more than 20 years, but the move was widely expected and investors instead focused on Powell’s comments at a subsequent press conference. Powell signalled that the Fed’s policymaking committee expected to implement 0.5 percentage point increases at its next two meetings, but was not “actively considering” a more aggressive 0.75 percentage point increase. He added, however, that the “if higher rates are required, then we won’t hesitate to deliver them”. The yield on the two-year Treasury note, which is particularly sensitive to central bank policy, dropped 0.13 percentage points after the press conference, to 2.64 per cent. Yields fall when prices rise. The yield on the benchmark 10-year Treasury dipped 0.04 percentage points, to 2.92 per cent, having climbed in the run-up to the announcement. Wall Street’s benchmark S&P 500 closed 3 per cent higher, its largest one-day gain since May 2020. The Nasdaq Composite, which was in negative territory shortly before the press conference started, ended up 3.2 per cent. Michael de Pass, head of linear rates at Citadel Securities, said the response reflected the fact that investors had priced in most of the Fed’s plans. “It was still hawkish overall, but there was a fair amount priced in . . . it’s not as if Powell did a complete 180, but the most hawkish scenario has been taken off the table for now — they’ve said ‘it will be 50 basis points for the next two meetings, and then we’ll reassess’.”
The market's response to the Fed hikes reveal an interesting this about it that I blogged here. It's now relieved that 75 basis points hike is off the table and there are only three 50 basis points hike for the year, and therefore it zooms over 3% in a day! If we recollect, even less than two months back, it was alarmed about the possibility of even one 50 basis points hike and I don't think any credible news source was even discussing a 75 basis points hike! In a few weeks, even as the fundamentals have worsened (in terms of more news about the impending economic downturn), the markets appear to have seen something else that merits continuation of its trend even with the guidance on two more 50 basis points hikes in the coming three months.
In the circumstances, it's hard not to see that forward guidance itself may be becoming a distortion. Fundamentally, market participants are disciplined by the uncertainties of the market. As Bengt Holmstorm and others have written, "asymmetric ignorance" (also here) is a virtue in the financial markets. The market participants should be more ignorant than the regulators. There's a disciplining force with such uncertainty.
The regulators should not be trying to reduce this disciplining force of "market uncertainty" when we are in the midst of the longest bull market in history. The market participants should remain exposed to the full force of the market uncertainty, also especially when the regulators themselves are not sure about their own forward guidance. This is furthermore so given the well-known trend of the markets reacting more positively to good news than it reacts negatively to equivalent bad news, assuming both come at uncertain times.
There is another reason. Markets gradually price in the formal guidance. Simultaneously informal gossip raises the possibility of more/greater increases. A new anchor emerges for monetary policy uncertainty, which has little basis except that the old anchor has been dissolved by the guidance. When the decision already priced in by the forward guidance is announced, the markets react euphorically, relieved that the gossip has not materialised. It's almost like the markets collectively decide to set up a straw man scenario to keep the party going.
Since the market response to the guidance is longer drawn, they generally tend to undershoot in their response to the guidance. In contrast, the sudden relief ends up overshooting on the gossip not materialising. In the net, the gossip, triggered only by the forward guidance, ends up boosting the market more than the guidance would have wanted. The markets end up selling on the guidance and buying on the gossip. And since the latter is generally larger in effect than the former, the net result is that the markets end up moving further ahead. Monetary tightening ends up being effectively a loosening, or at least not a tightening.
Accordingly, far from tightening, the Fed's transparency in communicating that it's not considering a 75 basis points hike, appears to have shaped market expectations that are likely to end up effectively loosening market conditions, or atleast not tightening to the extent that would otherwise have been possible. As a counterfactual, if the Fed had not communicated this, it would have left the markets on their toes and the uncertainty would have forced greater risk mitigation measures and greater caution among participants. Now the Fed communication has effectively ended up distorting the market response. The asymmetric ignorance on the extent of future rate hike possibilities would have induced greater caution and have had a market disciplining impact.
There are also two asymmetricities here in the market's response to different kinds of news. The first is regarding the market's response to bad and good news, and the second is with respect to the materialising of formal guidance and informal gossip. In both cases, the markets overshoot on the upside news (good and gossip) more than on its undershoots on the downside news (bad and guidance).
This is also a good example of how academic research built on ideal markets and divorced off understanding of market psychology can worsen the problem. When Michael Woodford et al came up with their forward guidance theory in the aftermath of the global financial crisis, little did they realise the damage they would be doing over the coming decade. This is the latest example of expert opinion turning out to have worsened the problem.
In The Rise of Finance, co-authored with Dr V Ananthanageswaran, we had written about the near complete capture of regulators and central banks by the financial market interests. For all talk of central banks now breaking that stranglehold on the face of the rising inflation, the ideological and institutional capture is such that it'll be some time, if at all, before they can break free on their own.
I think the RBI did a clever thing by intervening just before the FOMC and that too with the 40 basis points hike. The 40 basis points (and not 50) also perhaps reveals that the RBI is not yet fully convinced that it's behind the curve big time. It did some catching up, though much remains to be done. In fact, it's telling that of the 22 countries that have raised rates in recent days, 15 have done by 50 basis points or more, and RBI is among the seven in the minority.
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