Books and degrees can provide an excellent framework, but to truly understand markets, you have to experience them. I’ve seen my share of tumultuous cycles over 36 years in the world of finance, which some may say has provided me an experienced perspective, while others might argue has made me a jaded, irreverent, grumpy old man. I suspect both are true.
I learned in the private sector that the trading world is one that is dominated far more by reality and far less by theory. The text book may postulate that markets are rational, but more often than not, the reality of a trader's profit/loss statement at the end of the day would not agree. Further proof of that is looking into the eyes of a trader who has based his strategies on macroeconomic fundamentals but is marked to market daily. For much of the time, these eyes usually twitch.
The central bank world is dominated by theory. Here, incoming reality, be it monitoring economic data or listening to market “chatter”, was heralded gloriously if it fit with what theory would have predicted. Any transgressions, however, would be downplayed or set aside and given more time to allow reality to come to its senses and catch up to the text books.
The essence of a central bank’s culture was captured beautifully by an article recently sent to me. The piece was written by W. Ben Hunt and is entitled “Viewing Capital Markets through the lenses of Game Theory and History”. In the note, Hunt commented on the internal political workings of a central bank.
To paraphrase at a high level, he said that “the spirit, culture and personnel composition of a central bank (Fed) is almost identical to that of a large research university”. Thus, the motivation for many at a central bank is their academic reputation, not results. Particularly at the analytical staff levels, I would add that they feel more accountable to following robust economic theory and maintaining rigorous models than to the actual results they produce.
Ben Hunt further wrote, “At the central bank, your internal reputation is entirely based on how academically smart you are. This is measured by what papers you have had recently published and what conference you presented at, with little weight on anything practical. Every hour you spend doing outreach to commercial bank staffers is an hour you are not spending impressing your bosses with how smart you are.” What ensues is “a huge desire to form a consensus with other smart people so each of you is recognized by the other members to be smart enough to be a member.” Woody Allen could not have said it better.
The two worlds could not be more different. The markets being dominated by reality which is irrational, bumpy, harsh versus the theoretical world of how the markets work which is rational, smooth, kind. One world focused on the immediacy of results, versus the other on “in four to six quarters from now.”
The problem is that both worlds have become more and more dependent on the other. Monetary policy is transmitted through markets to the real economy and the markets are priced off of expectations of probable central bank actions. They need to understand each other, but with different objectives, different risks and different timelines, one could say that the markets are from Venus and the central bankers from Mars.
Since the financial crisis, this has not been an issue. Both sides have been rooting for the same thing, higher financial asset prices but obviously for different reasons. Market practitioners want to protect and grow capital, and central bankers want more accommodative financial conditions to spur economic activity. This has required extraordinary efforts on behalf of the central banks including pushing reality into the theoretical world of negative interest rates. This action by some banks, along with other monetary policy tools has suppressed the harsh, bumpy world for markets. As economies (read US) recover and find their footings, the alignment of the two worlds described above will dissolve. The clash between the two worlds will become more evident.
Volatility will increase and importantly, the central bank will have less at stake in constantly rising asset prices. That is not their mandate and I think this will come as a surprise to many. I am old enough to assure people that thirty some years ago there was no such thing as a Volcker “put”.
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