What's been amazing of late hasn't been the market swings but the extent to which central bankers have contributed to them. Every press conference, statement and newspaper leak of central banks has been pre-empted, interpreted and re-interpreted - all in real time and often within seconds. Investor dependence on the thoughts and actions of central banks isn't new, but it seems to have reached unparalleled and absurd heights.
The big question is: why? The obvious answer is that the trend has been driven by greater central bank intervention in markets via quantitative easing (QE) and zero interest rate policies. But Asia Confidential suspects there's more to it than that and the field of psychology may offer some clues. For instance, it's well documented that people have a tendency to defer to authority, particularly in times of crisis. Could this explain at least some of the investor behaviour towards central banks? It's worth exploring given the apparent reliance of stock and bond markets on the world's central bankers. At a minimum, being aware of possible investor biases, including your own, could put you one step ahead of others.
Reading Fed tea leaves
Will the U.S. Federal Reserve slow stimulus or not? That's been one of the big questions on the minds of investors over the past month. We first had rumours of a Wall Street Journal article suggesting the Fed had mapped out a strategy for the winding down of QE. Then the article came out a day later, confirming the rumour. Since that time, various Fed members have come out publicly, some pushing for an end to QE, others for its continuation. The release of Fed Open Market Committee (FOMC) minutes on Wednesday gave us some more clues. Or did it?
Let's first take a look at some of the key passages from the minutes:
"A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome. One participant preferred to begin decreasing the rate of purchases immediately, while another participant preferred to add more monetary accommodation at the current meeting ... Most participants emphasized that it was important for the Committee to be prepared to adjust the pace of its purchases up or down as needed."
"... participants generally continued to expect that inflation would move closer to the 2% objective over the medium run. Nonetheless, a number of participants expressed the concern that inflation was below the Committee's target and stressed that future price developments bore careful watching ... A couple of participants expressed the view that an additional monetary policy response might be warranted should inflation fall further. It was also pointed out that, even absent further disinflation, continued low inflation might pose a threat to the economic recovery by, for example, raising debt burdens."
Confused? You should be, as the markets certainly were. The S&P 500 initially rose on the comments and later fell on those same comments.
It became clear to many investors that the statements contained little fresh information. In essence, the Fed will play it by ear. If the economy improves, it'll scale back stimulus. If the economy doesn't improve, the current stimulus will remain.
But that didn't stop the commentariat from using the minutes to support their points of view. The bulls emphasised that the U.S. economy was improving and though QE tapering may take place, it wouldn't have a negative economic impact. The bears suggested that the U.S. economy was showing signs of deceleration and there's no way that the Fed would reduce stimulus. In other words, the minutes suited everyone, and no-one, because they were open to many interpretations.
There are two things to note about the reaction to the minutes. First, it shows the extraordinary power that the Fed has over markets now. It's amazing to think that Bernanke's predecessor, Alan Greenspan, has been utterly discredited for his part in creating the credit bubble. And even though Bernanke was at the helm when the Fed had no clue about the pending bubble, his reputation, and that of the Fed, has not only stayed intact but grown.
Second, does the obsessive focus of investors on the Fed distract them from more important issues? For instance, let's look at the potential impact of a normalisation in U.S. interest rates. Currently, the interest paid on U.S. government debt is about 1.5% of GDP. In a US$15.7 trillion economy, that's about US$235 billion in interest paid.
If you saw 10-year bond yields rise from close to the current 2% to the long-term average of 6.6%, the interest on government debt could multiply. The U.S. could possibly be paying US$500 billion or more in interest, on top of that already being paid. That's a lot and would more than offset GDP growth of 2%, perhaps rising to 3% if the economy improves.
To put the possible increased amount of interest paid into context, it could dwarf the recent so-called sequestration cuts of US$85 billion. More interest paid on debt would mean less money elsewhere and likely more serious government cutbacks. And that's assuming that bond yields don't spike above long-term averages.
Would Bernanke really allow that happen? Probably not. Particularly when the less painful way to reduce debt and the interest paid on that debt is through inflation via QE.
Japan's bizarro world
If investors are stalking the Fed's every move, they're doing the same thing with the Bank of Japan (BoJ), and to a degree that's becoming comical.
The background is that the new government installed a new BoJ chief, Haruhiko Kuroda, in March. Kuroda's mandate was to print a bucket load of money to buy bonds and stocks in order to reinvigorate the economy and end 15 years of deflation.
Investors have warmed to the story, sending stocks up nearly 40% and the yen down 18% this year. That's despite stimulus only recently being initiated and the evidence of success or otherwise still not yet known.
The story's positive glow has taken a darker turn over the past week though. On May 22, commenting on the sharp spike in Japanese government bond (JGB) yields, Kuroda said that gains in yields should be expected as the economy improves. The problem was that he'd previously said that the central bank aimed to lower interest rates. It sent the Topix index down 6.9% on the day, the largest decline in two years. And bond yields swung 17.5 basis points intraday, briefly reaching a one-year high of 1%.
A three year chart of 10-year JGBs is shown below, courtesy of Bloomberg.
Then the next day, after a further spike in bond yields, Kuroda said the stimulus already announced by the government was sufficient but conceded he needed to communicate better with markets. The stock market swung wildly as Kuroda spoke, and after, moving 6% intraday, but finishing slightly up.
The problem, of course, is that investors had put total faith in Kuroda's ability to turn the economy around and that faith's now being questioned. The question is why investors had such faith in the first place.
Also, the focus on the BoJ's every move may mean investors are ignoring more pertinent issues. For example, if the BoJ succeeds with its aim to raise inflation to a targeted 2%, that means interest rates will rise. With interest paid on government debt equivalent to 25% of Japanese revenue, any rise in rates could prove diabolical. If the BoJ doesn't succeed, the enormous government debt load will compound and bond markets may eventually revolt. It seems like a lose-lose situation, and if that's right, the BoJ's every move takes on less importance.
Cognitive biases at work
What's behind this investor obsession with central banks then? It's obvious that central bank invention in bond and stock markets (direct and indirect) is greater than at any time in recent history. Undoubtedly, investors are struggling with this. Normal market operations are no longer normal. Investors have had to turn into part-time political scientists in order to anticipate market movements.
But is there more to it? I'd suggest that there might be and investors could be turning to time-old psychological biases to try to cope with the new environment.
Of course, the application of psychology to finance, known as behavioural finance, isn't new. It's a growing area of study though given the recognition that most investors are far from rational actors when it comes to markets.
Anyhow, here are five psychological biases that may explain some of the recent obsession with the actions of central banks.
- Deference to authority. Studies have shown that people defer to authority, particularly during extreme crises. Stanley Milgram conducted the most famous experiment into this in 1963. The context for the experiment was that after World War Two, many wondered how ordinary people could commit unspeakable crimes. Milgram sought to test this in a laboratory to see how far people would go when an authority figure ordered them to hurt another human being. The shocking answer was: very far. While an extreme example, the lesson for investors is that many people will often do what an authority figures tells them to do, either overtly or otherwise.
- Conformity, or the herd principle. The best-known study on this was done by Solomon Asch in the 1950s showing that people will deny evidence from their own eyes to fit in with others. This suggests that groups exert a tremendous influence over individual decision making.
- Group conformity. A corollary of the above is that people conform more strongly with others that are in the same group as them. If your an economist, you're more likely to conform with the thinking and actions of other economists.
- Cultural conformity. Collectivist cultures, particularly in Asia, are more conformist in their behaviour. This is because non-conformity is seen as deviance. Average conformity rates range from 25-58% in collectivist cultures compared with 14-39% in so-called individualist cultures. This explains much about Japan...
- Adherence to social norms. Other people affect us even when they're not there. Studies by Robert Cialdini suggest that most people are strongly influenced by thinking about how others would behave in the same situation, particularly if they're unsure how to act. For instance, a decision about whether we buy into the stock market is often influenced by society's view of such a purchase. That makes for bad investing!
These are just some of the biases that may have contributed to the heavy reliance of financial markets on the words and deeds of central bankers.
Bias awareness means better investing
An understanding of these psychological biases is critical if you accept that they may be behind at least some of the investor behaviour of late. An awareness of the biases means that you can work to minimise them if they're impacting your own decision making. Minimising psychological biases can make for more rational, objective investment decisions. And a tidy edge over others.
This post was originally published at Asia Confidential (http://asiaconf.com).