On September 17, traders from all over the world sat at their desks nervously in anticipation of Federal Reserve Chairman Janet Yellen’s press conference, where she announces the FOMC’s interest rate decision. Anticipation and nervousness are, at best, euphemisms to describe the build-up; never in history has the Federal Reserve’s decision on monetary policy drawn so much attention and debate from finance professionals and influential economists due to uncertainty and weakness in emerging markets from the commodity slump, persistently low inflation, and the strength of the dollar.
Eventually, the Federal Reserve chose to keep interest rates unchanged at 0.25%, ending a long-drawn saga of speculation and predictions, and continuing on an even longer saga of historically low interest rates. Given the outlook of the world economy and some negative U.S. indicators, majority of analysts in Wall Street predicted that rates would stay the same, despite the Federal Reserve making it strictly clear under their forward guidance policy that rates would increase in September. Janet Yellen and the Federal Reserve board members were not going to make a misstep in their efforts to ensure the U.S. economy is healthy enough to endure a dose of basis point increase after nearly a decade.
However, one fundamental issue gets raised through this episode. Before elaborating on this issue, it’s essential to understand the advance developments in financial markets. Financial markets are at the pinnacle of sophistication in the modern age; information, speed and efficiency of trading, and the range of financial products undoubtedly makes this one of humankinds greatest, and biggest innovations since the digital revolution. Equities, bonds, currencies, commodities, options, futures, derivatives; anything you want to trade, you can find in this comprehensive library, all at the click of a button on your computer or smartphone. Apart from the initial monetary investment, barriers to entry for financial markets are almost non-existent; everyone has the capacity and freedom to trade. With the flood of newcomers hoping to profit from the markets, information services such as Bloomberg and Thomson Reuters, along with specialized forecasting tools as part of technical analyses, have established their necessity to investors, and increased transparency of financial markets. Long story short, financial markets have come a long way since its humble beginnings.
Financial markets also shine light on information about the economy. Stock market indices, for example the S&P500, Dow Jones Industrial or FTSE100, to some degree reflect business cycles; performance from large, public corporations strongly influence consumption, inflation, investment and unemployment to name a few, and these indices are comprised of these big players. Similarly, the trends in relative strength of a currency to another highlight expectations in future economic performance, for example when China announced a slowdown in growth during the second half of 2014, emerging market currencies that rely heavily on commodity exports slumped, with the AUD, NZD, and CAD having fell by 22.4%, 22.3% and 20.4% respectively against the USD as of 17 October 2015.
With this amount of symmetric information, investors speculate and take action in the market based on their expectations of price ups and downs. To profit from speculation, investors have to trade long or short (otherwise it is no different from fortune-telling), and depending on demand and supply, prices will change. With confidence, we can state that investor speculation is dependent on data and information, but could the same be said for government intervention after what had happened last month?
Therefore, the issue is this: “who manipulates markets, investors or the Central bank (representative of government intervention)?”
Back to the situation that caused this issue to arise. The Federal Reserve had intended to raise rates on September following sustained improvements in U.S. data, but stayed put in the end by unfavourable conditions outside, and incomplete conditions inside of the U.S. economy. However, Janet Yellen maintained her view that a rate hike is still on the cards for this year. Treasury traders on the other hand, think otherwise, now expecting the increase would be delayed until March 2016, according to the 10 year U.S. government bond yield term structure shown below.
As written on Bloomberg, “The benchmark 10-year note yield fell seven basis points, or 0.07 percentage point, to 1.97 percent as of 5 p.m. in New York, the lowest on a closing basis since April 27, according to Bloomberg Bond Trader data.” (Full article here). Bond markets, the largest financial market by value, illustrates the market, and therefore investors’ expectations in interest rates.
On the other side of the world in Europe, ECB President Mario Draghi is losing credibility from traders that his monetary policy strategy is weakening the Euro. Neo-classical economics tell us that expansionary monetary policy such as ‘Quantitative Easing’ would depreciate the currency since investors search for higher yields elsewhere, but the Euro has recently experienced a resurgence, up 8.2% from the lowest point ($1.046) as a result of strong data from the Eurozone.
While Mr. Draghi has asserted his intentions for further QE which should keep the Euro in-check, ultimately, the market consensus says otherwise. Even before the QE was announced, the Euro depreciated nearly 33% against the dollar, which implies that investors predicted this move by the ECB. Moreover, investor’s were just utilizing another law from international economics; under the UIP arbitrage theory, the domestic interest rate (i.e. Euro) must be lower than the foreign interest rate (i.e. USD, but other currencies can take its place) by an equal amount to the expected appreciation. Investors speculated that QE would revive the Euro (future appreciation), hence the Euro needed to depreciate in the current period. The same, but reverse situation could be expressed for the U.S. dollar, where it has outperformed most currencies after the Federal Reserve’s forward guidance indicated an interest rate lift in 2015, and is now experiencing slight downward fluctuations, vexing dollar bulls.
Investors act upon data and forecasts; this is undeniable. Paradoxically, economic-wide data, the most important set of data, is provided by official government agencies. Data on unemployment, nonfarm payrolls, GDP and inflation, for example, always receive investors’ full attention whenever they are announced. It is difficult (bordering on impossible) to verify the accuracy or legitimacy of data provided by the state; China has raised suspicions upon its GDP statistics on several occasions before. Does this, conversely, suggest that investors are being manipulated by the state? Not necessarily. For example, if the data was bad, what message does the government get across to the public? “I’m not terribly well at doing my job” is the likely opinion. Good data is always a merit, and bad data is always bad unless there is merit for the government to publish fabricated data that does not meet expectations.
Investors move the markets, and government intervention significantly affects their decisions; in the past this relationship is one-way. However, with sophisticated analytical techniques, plethora of instantaneous information and the pressure on economic superpowers to avoid another financial crisis, investors now have a degree of influence over how the economy and financial market plays out.