One recurrent theme of these missives is that financial markets are always changing. What used to be a reliable relationship one day, all of a sudden stops like the relationship between the quantity of money and inflation or US interest rate moves and the Dollar exchange rate. The problem is that there is no law of gravity in finance, something that is unchangeable and reliable no matter the circumstances.
To use some examples from the world of economics. If you see consumer price inflation unexpectedly increase, you would expect interest rates to rise and stock prices to fall a little bit because higher interest rates translate into higher discount rates and thus lower present value for future earnings of companies. If you see a positive surprise in GDP, you would expect both interest rates and stock markets to rise as an expression of strong demand for goods and services which boosts stock markets. Meanwhile, stronger GDP growth should lead to interest rate hikes by the central bank in the future, so interest rates should rise as well but not enough to turn stock market gains into losses. Everyone who has studied finance or has sufficient experience in the markets knows that this is how markets work.
And then something changes that at first seems to have no influence on these relationships and yet, everything turns upside down. This, at least, is the conclusion I drew from reading a paper by Deepa Datta and his colleagues in the American Economic Journal. They looked at the reaction of equity markets, interest rates, and the oil price to different macroeconomic surprises. The trick is that they looked at the reaction from 1990 to 2009 and from 2009 to the end of 2015. The difference between the two periods? In the first period central bank interest rates were positive, and in the second period, they were zero (or as close to zero as makes no difference).
The chart below shows the reaction of equity markets to macroeconomic surprises before and after the introduction of zero policy rates. I have taken three major macro indicators and the average of the 12 indicators analysed in the original paper. The changes are striking. Before the financial crisis equity markets were less sensitive to unemployment data than afterward and more sensitive to inflation surprises than afterward. But most surprisingly, a positive GDP surprise no longer triggers an equity market rally. In a world of low interest rates, the effect of rising interest rates dominates the effect of rising demand and equity markets start to drop in response to a positive growth surprise. Similar things happen to other macro indicators and the average response of equity markets to surprises in the 12 most important macro indicators today is not only stronger than before but also goes exactly in the opposite direction. It is as if we have to re-learn how to interpret macro data.
Equity market reaction to macro surprises
Source: Datta et al. (2021)
The same can be seen if we look at the reaction of 2-year Treasury yields to macro surprises. Stronger than expected GDP growth still leads to higher interest rates, but to a lesser extent than before. Meanwhile, higher than expected inflation leads to lower interest rates while higher than expected unemployment rates to higher interest rates. Now here is something that i) shouldn’t happen, and ii) I can’t explain.
2-year Treasury reaction to macro surprises
Source: Datta et al. (2021)
As I said before, the world has changed significantly since the financial crisis and if you rely on the same rules that have served you well until 2008, you all of a sudden may find yourself in a situation where your investments don’t perform anymore. Whether we are talking about bonds vs. equity, value vs. growth, Dollar vs. Euro, a world of zero interest rates has very different rules than a world of positive interest rates. And we all better learn these rules and fast.