The following news account[1] from the Bloomberg on Friday’s discernible jump in the US equity markets reasonably encapsulates what has been driving the global markets for a long time—financial markets highly dependent on political actions.
U.S. stocks advanced, giving the Standard & Poor’s 500 Index its longest streak of weekly gains since February, amid speculation of an agreement to contain Europe’s debt crisis and further Federal Reserve stimulus.
How Strong will the Market’s Expectations be?
So let me play the devil’s advocate: what if the market’s deepening expectations of the political resolutions from the above predicaments does not materialize?
These may come in many forms:
-adapted political actions may be inadequate to satisfy the market’s expectations (possibly from divergences in commitments or the inability to ascertain the optimal adjustments required)
-expected political actions don’t take place (possibly due to schisms or continuing disagreements over the measures or dissensions over the enforceability, degree of participations and or divisions over the efficacy of proposed measures)
-the festering crisis unravels faster than the applied political measures (possibly from miscalculations by the political authorities on the scale of the crisis or from unintended effects of their actions)
-sanguine markets expectations for an immediate resolution erode from either procrastination or persistent irresolution or indecisions (possibly from a combination of the above factors—divergences in calculations, variances in tolerable commitments and doubts on enforcement procedures and dissimilar political interests in dealing with the above junctures or more…)
October 1987 Risk Paradigm
I am in the camp that says that current dynamics suggest that the risks of a US are not as material as many mainstream experts have been projecting. Most of their projections have political implications, the desire for more government interventions.
But there could be a marked difference; stock markets may not be reflective of the actual developments in the real economy. In other words, actions in the stock market may depart from the economy.
Has there been an instance where there had been an adverse reaction to the stock markets from unfulfilled expectations from policymakers which had not been reflected on the economy?
Yes, the global stock market crash of October 19, 1987.
From the US Federal Reserve of Boston[2],
While in hindsight the data provide no evidence that interventions in foreign exchange markets were used to signal policy changes, it is possible that, at the time, market participants interpreted interventions as signals of future policy. If so, significant movements in the exchange rate would be expected at the time of interventions. Central banks actively intervened in foreign exchange markets after the Plaza Accord. Evidence suggests that combined interventions to increase the value of the dollar during this period did result in a significant decline in the deutsche mark/dollar exchange rate. As it became apparent that intervention was not signalling monetary policy changes, market participants apparently stopped interpreting intervention as a signal.
In short, market expectations diverged from the results intended from such political actions.
Many tenuous reasons have been imputed on non-recession stock market crash of 1987. However, the major pillar to this infamous event has been the boom policies of the Plaza Accord of 1985[3] which had been meant to depreciate the US dollar against G-7 economies via coordinated foreign exchange interventions, and the subsequent Louvre Accord of 1987[4], which had been aimed at arresting the decline of the US dollar or the reversal of the policies of Plaza Accord.
What had been initially perceived by policymakers as a US dollar problem, emanating from the advent of globalization, technological advances and the gradual transitory recovery of major Western from the recession of the early 80s, which affected the ‘goods’ side of the global economy, and the increasing financial globalization of the US dollar from the hyperinflationary episodes of some emerging markets (e.g. Latin American Debt Crisis[5]) which affected the ‘money’ side of the global economy, essentially transformed into a problem of policy coordination of interest rates[6] that led to an abrupt tightening of previously loose monetary policies which eventually got vented on global stock markets.
The decline of the trade weighted US dollar (apple green) stoked a boom in the US S&P 500 and similarly on the CRB Precious commodity metals sub-index (red) and an increase in inflation expectations as measured by the 10 year yield of US Treasuries (green). The yield relationship difference between stocks and bonds became unsustainable[7] which consequently culminated with the historic one day decline.
True, the dynamics of 1987 has been starkly different than today. We are experiencing a contiguous banking-welfare based crisis today which had been absent then in 1987.
But one striking similarity is how market expectations, which have been built on political actions, had completely diverged from what had been expected of the directions of policymaking.
Nevertheless the recent temblors experienced by the global financial markets following US Federal Reserve Chair Ben Bernanke’s no ‘QE’ stimulus[8] during last September 21st resonates on a ‘1987 moment’ but at a much modest scale.
This is NOT to say that another 1987 moment is imminent. Rather, this is to say that the sensitiveness to such market risks increases as political actions meant to resolve on the current issues remain ambiguous or will remain in an indeterminate state.
And this is to further emphasize that while a grand “aggressive” “comprehensive” strategy may forestall any major market convulsion for the moment, they are likely to be temporary measures targeted at buying time for the policymakers from which another crisis would likely unravel in the fullness of time.
For now, it would be best to watch closely on how policymakers will react.
I believe that a monumental buying opportunity may arise soon.
[1] Bloomberg.com S&P 500 Caps Longest Weekly Gain Since Feb., October 12, 2011
[2] Klein Michael Rosengen Eric Foreign Exchange Intervention as a Signal of Monetary Policy US Federal Bank of Boston, June 1991
[3] Wikipedia.org Plaza Accord
[4] Wikipedia.org Louvre Accord
[5] Mises Wiki Latin American debt crisis
[6]Ryunoshin Kamikawa The Bubble Economy and the Bank of Japan Osaka University Law Review, 2006 In the U.S., on the other hand, the new FRB Chairman Alan Greenspan raised interest rates in September. However, the dollar depreciated. Then, the U.S. government requested Japan and West Germany to reduce interest rates. Both countries declined and the Bundesbank performed an operation for increasing in the short-term interest rates in the market. Secretary Baker resented this and stated that the U.S. tolerated a weaker dollar on October 16. Investors recognized that this statement meant the failure of international policy coordination and they moved their financial assets out of the U.S. for fear of collapse of the dollar. This caused the heavy fall in the New York Stock Exchange on October 19 (Black Monday). The depreciation of the dollar continued after that and inflated asset prices and bond prices collapsed in the U.S. Then, Secretary Baker persuaded West Germany to lower the short-term interest rates)
[7] Mises Wiki Black Monday (1987)
[8] See Bernanke Jilts Markets on Steroids, Suffers Violent Withdrawal Symptoms September 22, 2011
