11
Mar
2015
Are Markets Myopic?
My sources say no. From my latest at FEE:
Notice that even if a particular owner of a tin deposit is diagnosed with terminal cancer, he still has an incentive to behave in this “efficient” manner. The reason is that he can sell the tin deposit outright. The market value of the entire deposit will reflect the (present discounted) future flow of net income derived from owning the deposit and operating it in the optimal manner indefinitely. If the owner ever thinks, Well, if I had 10 years left, I would run the operation in such-and-such a way, then that decision won’t change just because he only has one year left. Instead, he can sell the operation to the highest bidder, including people who do have 10 or more years left of expected life.
Ironically, I just pointed out in a comment at Scott Sumner’s blog that the market wasn’t at all forward-seeing on Greece even as late as 2009. I think Bob once also made a post against EMHist Gene Fama.
http://www.themoneyillusion.com/?p=28853&cpage=1#comment-381927
Bob, don’t your inflation views imply that markets are *very* myopic? The yield on 30-year Treasuries today is 2.69%. This is essentially a market forecast for 30 years of low inflation! (Of course, the further out we go, the less a spike in inflation matters today.) Yet you are confident that we will see high inflation in the next few years.
How do you reconcile these facts?
I’m not as certain that it’s a “market forecast for 30 years of low [price] inflation” as you are, Gene, but I am not sure how to reconcile the two things. At the very least, I should’ve put in a sentence in the FEE piece saying something like, “This is not to suggest that market prices are always near the correct value, but rather to dispose of the typical objection that by their very nature, markets are ill-equipped to handle long-term planning.”
OK.
How many investors in 30 year bonds expect to hold them until maturity? Not many in today’s speculative environment.
Also, the notion that 2.69% on the 30 year implies “low” price inflation for the next 30 years is only true if bond investors are using the standard bond pricing models, which is a stretch given that they were created under (pseudo) gold standard conditions and are not inclusive of other factors that lower the yields, such as wildcat central banking.
“How many investors in 30 year bonds expect to hold them until maturity?”
Irrelevant. If they are going to sell them at a profit, they will have to sell them to other people with low inflation expectations.
“Also, the notion that 2.69% on the 30 year implies “low” price inflation for the next 30 years is only true if bond investors are using the standard bond pricing models…”
If you are earning 2.69% and inflation goes to 5%, you are losing lots of money, whatever pricing model you use. This would, in fact, be a case where you just don’t need a pricing model: inflation > yield = BAD DEAL!
“Irrelevant. If they are going to sell them at a profit, they will have to sell them to other people with low inflation expectations.”
Who said those buyers would hold the bonds until maturity?
If you have the opportunity to make 269 basis points annualized risk free for a few months, the CPI going up by 500 basis points would not necessarily matter to every investor.
“If you are earning 2.69% and inflation goes to 5%, you are losing lots of money, whatever pricing model you use. This would, in fact, be a case where you just don’t need a pricing model: inflation > yield = BAD DEAL!”
You aren’t losing any money. You gained 269 basis points risk free annualized.
If you are a member bank, then holding reserves would gain you 25 bps from the Fed.
Most importantly, when the Fed is a buyer of 30 year treasury bonds, bond investors know that the Fed is not going to care if it ends up buying bonds at a price that you say would imply what the investors inflation expectation are 25 years down the road. Very few bond market investors of 30y expect to hold them until maturity. The rest don’t mind paying the high price, because they get 269 bps of risk free for a few months of years, and the Fed can incur the brunt of any REAL loss should inflation go up to 5% in a few yeara as you say.
The Fed being a major player changes all the rules.
Or sell to the Fed.
Given that the Fed can print money and doesn’t buy based on expectations, but buys based on targets and policy, you can hardly pretend this is a genuine market indicator.
There are always too many variables to find any clear example (as in the linked article on oil from 2008). An example of forward-looking in the markets is the current volatility in the equity market. It doesn’t make much sense out of context; in context, a change in fed policy has a long term effect when looking for the best return on investments…as liabilities are no longer constrained by fed interest policies money will flow from equities to bonds. The volatility is subject to guessing the timing of Fed decisions.
The more anti-market activity takes place, the more myopic market activity becomes.