I have been writing a lot lately about movements in the stock market and in interest rates, trying to interpret those movements within the framework I laid out in my paper “The Fisher Effect Under Deflationary Expectations.” Last week I pointed out that, over the past three months, the close correlation, manifested from early 2008 to early 2013, between inflation expectations and the S&P 500 seems to have disappeared, inflation expectations declining at the same time that real interest rates, as approximated by the yield on the 10-year TIPS, and the stock market were rising.
However, for the past two days, the correlation seems to have made a strong comeback. The TIPS spread declined by 8 basis points, and the S&P 500 fell by 2%, over the past two days. (As I write this on Wednesday evening, the Nikkei average is down 5% in early trading on Thursday in Japan.) Meanwhile, the recent upward trajectory of the yield on TIPS has become even steeper, climbing 11 basis points in two days.
Now there are two possible interpretations of an increase in real interest rates. One is that expected real growth in earnings (net future corporate cash flows) is increasing. But that explanation for rising real interest rates is hard to reconcile with a sharp decline in stock prices. The other possible interpretation for a rise in real interest rates is that monetary policy is expected to be tightened, future interest rates being expected to rise when the monetary authority restricts the availability of base money. That interpretation would also be consistent with the observed decline in inflation expectations.
For almost three weeks since Bernanke testified to Congress last month, hinting at the possibility that the Fed would begin winding down QE3, markets have been in some turmoil, and I conjecture that the turmoil is largely due to uncertainty caused by the possibility of a premature withdrawal from QE. This suggests that we may have entered into a perverse expectational reaction function in which any positive economic information, such as the better-than-expected May jobs report, creates an expectation that monetary stimulus will be withdrawn, thereby counteracting the positive expectational boost of the good economic news. This is the Sumner critique with a vengeance — call it the super-Sumner critique. Not only is the government-spending multiplier zero; the private-investment multiplier is also zero!
Now I really like this story, and the catchy little name that I have thought up for it is also cute. But candor requires me to admit that I detect a problem with it. I don’t think that it is a fatal problem, but maybe it is. If I am correct that real interest rates are rising because the odds that the Fed will tighten its policy and withdraw QE are increasing, then I would have expected that expectations of a Fed tightening would also cause the dollar to rise against other currencies in the foreign-exchange markets. But that has not happened; the dollar has been falling for the past few weeks, and the trend has continued for the last two days also. The only explanation that I can offer for that anomaly is that a tightening in US monetary policy would be expected to cause other central banks to tighten their policies even more severely than the Fed. I can understand why some tightening by other central banks would be expected to follow from a Fed tightening, but I can’t really understand why the reaction would be more intense than the initial change. Of course the other possibility is that different segments of the markets are being dominated by different expectations, in which case, there are some potentially profitable trading strategies that could be followed to take advantage of those differences.
It wasn’t so long ago that we were being told by opponents of stimulus programs that the stimulus programs, whether fiscal or monetary, were counterproductive, because “the markets need certainty.” Well, maybe the certainty that is needed is the certainty that the stimulus won’t be withdrawn before it has done its job.
PS I apologize for not having responded to any comments lately. I have just been swamped with other obligations.
Uneasy Money 
I think Japan is driving this. People don’t trust Japan to follow through with a 2% inflation target, especially in the face of market volatility and opposition elsewhere in Asia. Hence, stronger Yen (weaker Dollar), lower markets, tighter money. There’s a mild knock-on effect: if Japan isn’t committed, maybe the Fed won’t be either.
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David, I completely agree with Steve. This is the expectations of less monetary easing from the Bank of Japan. Take a look at USD/JPY and Japanese inflation expectations.
The rise in NOMINAL yields in Japan has caused the BoJ to make confusing comments about the outlook for monetary easing. There is clearly reason for the makes to fear that BoJ will not deliver on the promise to increase Japanese inflation to 2%.
The US stock market performance dependent heavily on the global economy – with the third largest economy not delivering the “promised” monetary easing equity investors are stepping back.
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Don’t overlook the illiquidity of TIPS, which distorts the spread with nominals. The real yield on the 10 year TIPS was near 3% during the depths of the 08/09 crisis, much (but not all) of it due to the illiquidity of TIPS.
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I would approach it this way: in the US non-measured inflation is rising (i.e., real estate) while measured CPI inflation remains weak, restraining TIPS (along with the liquidity effect). This partly explains the rising yields and falling dollar. Japan is a major factor in the sell off of equities, with the Nikkei down 31% from the peak (versus 5% for the US – well within expected volatility for the timeframe) and the JPY 30Y back within the last 10-year trading range. Note that when there is an economic regime change, like in Japan, a spike in volatility (up and down) is not unusual as investors argue over the meaning. There is evidence that China is weaker than generally understood, dampening both commodity demand (gold down 23% from October and Brent down 11% from February peaks) and UST prices, though that seems to be previously baked into China share prices.
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… Nikkei down 21%. The 3 is very close to the 2 on the keyboard; not vouching for my other math …
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David,
Imagine the Fed has an undisclosed NGDP level target. If the Fed shouldn’t taper now, then should it taper:
1) abruptly when it reaches the target?
2) gradually before it reaches the target?
3) gradually after it reaches the target?
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David, I agree with you completely. Though, I’d say this is a critique of the asymmetrically defined Evans rule, rather than QE itself.
It’s a point I made a few weeks ago here, http://ashokarao.com/2013/06/07/one-strike-for-the-evans-rule/ , if you are interested.
“Even then, the perversity of QE is clear. Obviously, considering QE’s transmission mechanism, asset prices have to increase. However, we should at least believe that a lot more of the stock market boom in the past few months is QE and AS rather than improvements in demand. Otherwise, today’s jobs report should have been met with a “meh” response from the Dow.
The thought experiment is this. Let’s say May was a fantastic month, and the BLS prints a fabulous report. Would the stock market go up? To the extent it falls, or doesn’t rise as we would hope to aggregate expected growth (which is high, because the market knows the economy has done well) – QE is a distortionary force. It’s not a bubble, but it clearly confuses markets.
A well-designed QE policy would offset the market effect of information from the jobs report vis-a-vis its “natural” trend. What does this mean? If the job market was booming investors would face two countervailing forces 1) an expected tapering of QE and 2) increasing consumer confidence and demand (which moves in line with the market). If the jobs report sucked, investors would be confident in continued QE, but worry about falling demand.
This is a sterile design that doesn’t approximate the real world, but can inform what a correct QE policy would look like. For one, the value of asset purchases would be proportional to (or correlated with) job creation.”
However, I also suspect that because Japanese stocks are driven by foreign investors, much of American volatility may derive thereof.
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Take a look at the graph of Japanese inflation expectations against the Nikkei, as put together by Marcus:
Perhaps you could rewrite your paper in Japanese, Tomodachi.
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“PS I apologize for not having responded to any comments lately. I have just been swamped with other obligations.”
Don’t worry, David Glasner, I understand, and I’m sure others do. Still, I look forward to when you can respond to my most recent question on your paper for the Fisher Effect!
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