Some of the bond market's wildest price swings since the financial crisis occurred Oct. 15, when short maturity yields moved more than 50 basis points intraday. What explains the sudden shift in bond market uncertainty that ended up with dramatic decreases in bond yields?
We would caution against too fundamental an interpretation of these moves. Rapidly declining yields often signal fear of recession or deflation, but on closer look, a different textbook offers a better understanding of the bond market's signals.
Psychologists Daniel Kahneman and Amos Tversky introduced the concept of “loss aversion” more than three decades ago in their seminal work “Prospect Theory: An Analysis of Decision Under Risk.” That work became the foundation of an emerging field of behavioral finance. Their theories gained credibility from their apparent ability to understand the factors leading up to and playing out during the 2008 financial crisis.
Loss aversion applied in the financial context holds that investors put greater psychological weight or importance on losses than on equivalent monetary gains. Hence, losses lead to much greater reaction than gains. On Oct. 15, trading volumes in the market that was at the center of these concerns — interest rate futures markets — were five times their normal levels.
Bond prices gapped higher, not lower, that day, so the massive surge in volume was driven by fears of losses arising from investors who were betting on interest rates to rise. Those investors rushed in to cover their short positions, driving up bond prices. Such a surge in volume suggests that loss aversion behavior explains the dramatic decline in interest rates.
FED HAD A HAND
Yet we should not dismiss out of hand the potential that fundamentals explain part of the decline in rates. For example, don't forget the Federal Reserve's communication of its concerns over falling global growth and the deflationary impact of a stronger dollar as a factor contributing to lower rates in October.
However, we see some key offsets to such concerns. Outside of falling oil prices, the pass-through of declining import prices arising from a stronger dollar into falling overall inflation historically has been negligible. And the decline in the contribution of net exports to U.S. growth will be more than offset by the benefit from the boost to domestic consumption arising from the increase in disposable income that's at least partly a result of the roughly $25 decline per barrel in global oil prices.
The rest of the world's troubles matter less for their direct impact on the U.S. economy — exports make up just 13.5% of GDP — though the confidence effects can create a bigger pass-through.
The best thing the Fed could do for global economic growth would be to stop delaying the eventual rise in interest rates. As U.S. rates rise, the resulting interest rate differentials (where, for example, U.S. rates rise relative to, say, European interest rates) would exert a revaluation pressure on the currency. A lower currency relative to the dollar for both Europe and Japan is the best hope monetary policy has left to help those ailing economies.
And though U.S. exports might suffer from the loss of competitiveness, the loss in growth from lost exports might be more than offset by the gains to what the Fed likes to call “financial market conditions” — in this case primarily a lower euro and yen relative to the dollar and, secondarily, higher European and Japanese stock prices.
FOMC STEPS SOFTLY
For the October Federal Open Market Committee meeting this week, however, such a shift in communication is probably unlikely. The Fed appears more concerned about the recent domestic market turbulence and its potential impact on investor confidence to do anything abruptly.
Of course, given a lack of inflation pressure, the Fed will raise rates very slowly once it determines there is sufficient data to justify its first move. But the reasons to start that process remain that emergency levels of monetary-policy support hardly seem consistent with an economy six years into a recovery in which the labor market is beginning to show signs of tightness rather than slack. Indeed, leading indicators of wage inflation suggest a significant rise in wages is around the corner. The Fed may well wait for that evidence to show up before making its move. But as the events of the last few weeks illustrate, the bond market — and investors' aversion to losses — may not.
Jeffrey Rosenberg is chief investment strategist for fixed income at BlackRock Inc.
