1. Making sense of the mayhem
When does a stock-market slide become a crash? And when does a financial crash spark an economic crisis? At the end of last year, few investors were giving much thought to such nice distinctions. Less than two months into 2016, with the leading global equity indices having dropped between 10 and 25 per cent at their worst, these questions are on everyone’s lips.
The turmoil in the equity markets should not really come as a surprise: the warning signs have been there for some time. Haggard veterans returning from other financial fronts – oil and metals exchanges; the emerging markets, including China; corporate bond funds – have been reporting heavy losses and instances of extreme volatility for more than 18 months. Safe-haven flows flooding into the soundest government bonds left more than $5trn of them yielding less than 0 per cent by late 2015; in effect, investors were paying governments for the privilege of lending to them. Even in the most liquid global asset class of all, the 24/7 market for foreign exchange, erratic behaviour has been on the rise. The Swiss franc, the world’s fifth most traded currency, jumped by nearly 30 per cent on one morning just over a year ago.
The potential of these dislocations to derail the UK’s economic recovery has not been lost on our policymakers. The Bank of England’s Monetary Policy Committee has comprehensively surrendered the idea of finally raising interest rates: its one member who had been voting in favour joined the more pessimistic majority earlier this month. The Chancellor, meanwhile, has been at pains in recent speeches to warn of the “cocktail of risks” facing the British economy. There seems little doubt, in other words, that the sudden acceleration of uncertainty on global financial markets is serious. But why is it happening – and what does it mean?
If the crisis of 2008 taught us anything, it is that, after three and a half decades of financial globalisation, we live in an uncannily interconnected world. A slide in the price of new-build homes in the suburbs of Las Vegas can lead to a death spiral in the shares of a German provincial bank. A squeeze in the market for an esoteric derivative product understood by only the two or three investment-bank rocket scientists in New York who designed it can force a collapse in a currency used by more than a billion people halfway round the world. The price of every financial asset is connected in some way to every other – and like the apocryphal butterfly flapping its wings and causing a hurricane a thousand miles away, a tiny bit of indigestion in the most innocuous of markets can precipitate violent convulsions elsewhere.
It is easy to assume that this complex web of interdependency makes the markets impossible to read – and in general, one should indeed be wary of plausible-sounding tipsters pointing to this or that particular share price as a sure sign that Armageddon or Nirvana is round the corner.
Yet although all financial prices are in this important sense equal, some are most definitely more equal than others. These days, there are three prices, above all the many thousands of others, which govern the global economy.
The first – probably the most fundamental of all, though by no means the most familiar – is the yield on the benchmark US treasury bond, the interest rate that the American government has to pay to borrow from savers for a term of ten years. This is the purest expression of the price of money: it captures the cost of acquiring purchasing power that you don’t already have in the world’s largest and wealthiest economy. It is also the best gauge of markets’ deepest fears – for when recession looms, investors want only the safest financial claims; and when disaster threatens, only claims on the US government will do. The whole world bids for US treasury bonds, making their prices fly and their yields plummet.
The second core price is better known. It is the level of the S&P 500 Index, the American equivalent of the FTSE 100: the price that summarises the value of the US stock market. The value of equity shares rises and falls with the waxing and waning of economic growth and corporate profitability – so this price measures the market’s appetite for risk, by taking the temperature of its enthusiasm for the largest, most productive and most inventive companies in the world.
The final member of this global financial triumvirate is the trade-weighted exchange rate of the US dollar, or its average exchange rate against the other major currencies of the world. The dollar is the world’s reserve currency – the one money that everyone, everywhere, is happy to use. It is the default denomination of every international debt contract; outstanding dollar loans to Chinese companies alone add up to nearly $1trn. When the dollar strengthens on the foreign exchanges, servicing dollar debt becomes more expensive. So this price calibrates the global cost of doing business.
These three prices exercise powerful gravitational pulls on every aspect of the world economy, like three moons inexorably drawing the global financial tides this way and that. As with real celestial bodies, when they are in alignment, the sea is smooth and investors enjoy plain sailing; but when their orbits diverge, we are in for equinoctial gales and rough crossings.
We need look no further than the current financial disruption for a case in point.
2. The markets’ trilemma
All three prices today stand close to historic extremes. At 1.75 per cent, the yield on the US treasury note is within touching distance of its all-time low in the modern era – 1.38 per cent, notched up in July 2012 at the height of the worldwide gloom over the euro crisis (see chart on page 27). The level of the US stock market, by contrast, is high; equity prices are “rich” after seven years of relentless rallies, even after the wobble of the past two months.
The dollar, meanwhile, is positively rampant. It has strengthened by 24 per cent against the US’s main trading partners in the past 18 months alone, and is more expensive than it was at the peak of the dotcom bubble in the late Nineties, when all everyone wanted was to own a bit of corporate America.
Separately, these prices may all make sense. When we try to fit all three together, however, the tensions underlying the current market turbulence become clear. Each of the three most likely short-term scenarios for the global economy is consistent with two of them. None is compatible with them all.
The first scenario to consider is the one the world’s policymakers are currently betting on: that the economic recovery in the United States, though a bit limp, remains on track. There may be icy winds blowing from China and the other emerging markets, and a lack of momentum in Europe and Japan. Yet fundamentally the US economy remains in good health, and the collapse since mid-2014 in commodity prices – from oil to copper and iron ore – is, on balance, a net positive for American growth.
The second scenario is the one that is all over the press: the US, and perhaps the whole world economy, is already in recession. China piled up a mountain of debt seeking to offset the negative effects of the last crisis, but that borrowing financed the construction of ghost cities and commodity speculation. Now the reckoning has arrived, the Chinese boom has gone into reverse, and the resulting fall in commodity prices is wreaking economic and political havoc from Riyadh to Rio de Janeiro – and even in the US itself.
The third scenario is superficially the least dramatic, and hence figures least in the news. It is that things have got neither suddenly better, nor suddenly worse. Fundamentally, the US and the world remain stuck in the same, mildly disappointing rut they have been in since 2009. Call it the “new normal”, call it “secular stagnation”, it is neither a proper recovery nor a new global recession: it is simply the familiar pattern of low growth, low inflation and low interest rates that we have been living with for the past seven years.
Which of these scenarios is the one we actually face? For the purpose of understanding the current market meltdown, it doesn’t really matter. The reason for investors’ manifest uncertainty is that none of these three scenarios is consistent with all three of the governing prices in the global system.
If the US recovery is intact, then a strong dollar and a fully valued stock market look reasonable – but US treasury yields should be significantly higher, reflecting the higher inflation and more hawkish monetary policy that robust growth inevitably implies.
If, on the other hand, the US is close to or in recession, then both low treasury yields and dollar strength could be justified as the product of a flight to the safest asset in the global system and its main reserve currency – but the stock market is hopelessly overpriced because profits are doomed to dry up.
If both these dynamic views turn out to be red herrings, and the US is to be stuck in the recent grind of low growth and low inflation for the foreseeable future, then it is easy to envision treasury yields staying low and equity markets staying high under the continuing influence of ultra-loose monetary policy. Yet by the same token, it is difficult to see why the dollar should keep up its stunning run: it has been the stark divergence in monetary policy – hawkish in the US, dovish everywhere else – that has propelled its dizzying ascent.
The problem is that one of these three scenarios (or something broadly similar) will eventually come to pass. When it does, at least one of the three master prices that govern the global economy will have to adjust, and probably rapidly. The markets are in the grip of a trilemma that will almost certainly prove highly disruptive – and investors are cottoning on.
3. Monetary policy rules, but for how much longer?
So much for the current market action and its proximate cause. What about the longer term?
The first and second scenarios – recovery and recession – at least have the virtue of being familiar. A global recovery would certainly be preferable to a global recession. But either scenario would at least restore confidence that the type of business cycle we have known for the past sixty years still exists. That would be important because it would mean that the conventional models of the economy remain valid, and policies derived from them the best bet there is.
The third scenario – a return to the lacklustre but at least relatively stable path of the past seven years – would be more worrying, for many investors. The reason is simple. It would reinforce the sense that neither investors nor policymakers really understand what is going on.
The key feature of the relative economic calm that the world experienced from 2009 to mid-2014 was the unprecedentedly loose monetary policy implemented by the world’s major central banks. Central bank interest rates in the US, the eurozone, Japan and the UK have been pinned close to zero. Policymakers have made delicately turned verbal commitments to keep rates low for a very long time – the policy experiment called “forward guidance”. Trillions of dollars, euros and yen, and hundreds of billions of pounds, have been freshly printed under the rubric of “quantitative easing” (QE) in order to make money still more freely available when the conventional strategy of cutting interest rates has been exhausted.
The striking thing about these policies is that they are only tangentially supported by the theoretical frameworks that these central banks use to understand the economy. As Ben Bernanke, the then chairman of the US Federal Reserve, put it in his final public appearance in office in 2014, “[T]he problem with QE is it works in practice but it doesn’t work in theory.”
People who don’t spend their time staring at Bloomberg screens might be forgiven for asking why this matters. If, as Bernanke says, QE works, then who cares whether we know why it does or not?
The reason is that all policy – and monetary policy more than any other kind – depends critically on people’s expectations of what its outcome will be and their confidence that the policymakers understand the mechanism. In the field of public policy, the risks of unintended consequences are always large. They are multiplied many times over if the people in charge cannot explain why their actions are producing a particular result.
The looming risk is that monetary policy – the one tool that governments have been willing to use aggressively over the past seven years – starts to lose its grip. If its potency depends on investors believing that central banks know what they are doing, but those central banks lose their credibility, monetary policy may cease to work.
The point is far from academic. At the end of January, the Bank of Japan surprised the world by announcing that its monetary easing had not, as many had assumed, reached its limits. Concerned that the turmoil on the markets would spark a strengthening of the yen, it took its policy interest rate into negative territory for the first time ever in order to discourage safe-haven flows to its currency.
Until now, the near-automatic effect of such a loosening has indeed been to drive investors into riskier yen-denominated assets and out of the yen altogether, leading to its sharp depreciation against other major currencies over the past three and a half years.
Now, it seems, the magic is wearing off. Bond yields dropped as expected, all right; but the yen did not comply. It has strengthened more than 4 per cent against the US dollar since the new loosening policy was introduced. The credibility of the Bank of Japan is fading. The market does not believe it can do what it wants to do – or even, perhaps, that it knows how its experimental interventions really work.
Investors’ bigger fear is that such doubts infect the Federal Reserve. The consequences
of such a crisis of confidence in the powers of the most central of central banks would be of an order of magnitude far more serious.
Ever since the collapse of the Bretton Woods system of pegged exchange rates in 1971, the sole guarantee that currencies will maintain their purchasing power, both domestically and abroad, has been confidence in central banks’ discretionary policies. A loss of faith in the consensus model of monetary policy would pitch us into the anchorless world that the architects of the Bretton Woods system always feared.
The past few weeks have been nerve-shredding for those who work on the financial markets. They should prepare for more of the same – and those who have nothing to do with the trading of stocks, bonds and currencies should ready themselves, too.
If it is belief in the power of loose monetary policy that has kept bond yields low and equity prices high, we should prepare for spikes in interest rates and stock-market crashes – with painful ramifications for companies and households that need to finance their activity. If it is confidence in the power of central banks to manipulate the value of their currencies that has bolstered the dollar and depressed the euro and the yen, then we should expect dramatic re-evaluations of these exchange rates, with inevitably disruptive consequences for global trade.
Over the longer term, the most consequential result of all will probably be an urgent search for a new framework for monetary policy, and above all for a new anchor. History – and, in the US, actively discussed political proposals – would suggest that the abandonment of discretionary policymaking in favour of formulaic rules, or even a return to a gold standard, are the candidates most likely to be chosen at short notice.
The sad fact is that these measures would represent last resorts from failure. Flexibility in monetary policy, credibly deployed, is probably the single most effective tool of government ever invented. It would be a confused and benighted age that chose to abandon it in favour of more primitive techniques of control.