This young lady seems to be taking notes on efficient markets theory. Photo by Isabel Pavia/Getty Images.
Friday’s US Employment Situation report showed hiring again topped 200,000 new jobs—beating expectations and theoretically clearing the path for the Federal Reserve to hike rates. That last part is subject to some interpretation, but at least if Janet Yellen’s comments on Thursday at Congress’ Joint Economic Committee hearing are any indication, the Fed is prepared to hike in two weeks. A day earlier, ECB head Mario Draghi announced the central bank would cut deposit rates (the rate paid to … err by banks) on excess reserves held at the ECB to -0.3% from -0.2% and extended its €60 billion monthly quantitative easing bond purchases by six months.
A slew of pixels have been spilled about all three of these stories. However, few notice some very important economic lessons at work. Here are a few the careful observer can glean—some timeless, some with more timely applications.
Lesson #1: Markets Move in Front of Widely Expected Events
We’ve discussed this first lesson numerous times, and in many different contexts. And it was beautifully displayed yet again this week. In the run up to the ECB announcement, the euro weakened markedly ahead of the anticipated expansion of monetary policy. All else equal, currencies tend to flow towards regions with higher interest rates. But investors also try to anticipate those rate differentials. Note: This is the exact same thing that happened before the ECB introduced its QE program in March. Exhibit 1 shows the weakening euro against the US dollar before the two announcements.
Remember this lesson when the Fed meets in two weeks. Given the degree to which it has been discussed, it is highly likely markets already reflect the impact of an initial hike.[i]
Exhibit 1: US Dollar Per Euro Exchange Rate in 2015 to Date
Source: FactSet, as of 12/04/2015.
Lesson #2: Markets Rapidly Discount Widely Known Information
The currency’s reaction to the announcement puts the exclamation point on Lesson #1, and adds another. We’ve long argued investing based on information everyone knows is an erroneous practice, because liquid markets discount information near instantaneously—you can’t invest based on “news” after it is actually “news.”
Exhibit 2 plots a minute-by-minute look at the dollar/euro exchange rate. The ECB published its press release noting broad policy brushstrokes shortly after at 1:30 PM in Frankfurt, Germany (4:30 AM Pacific Standard Time). The press conference began an hour later, when Draghi gave more details. The reaction is near-immediate. As shown, apparently, markets had not only discounted the move—but discounted a bigger move than the one that happened. The euro had weakened in anticipation of more stimulus, and when Draghi’s announcement fell short, it jumped.
Exhibit 2: Dollars Per Euro, Intraday Minute-by-Minute, 12/3/2015
Source: FactSet, as of 12/04/2015. Times are in Pacific Standard Time, as this is the applicable zone where the author is sitting.
Lesson #3: All Sufficiently Liquid Markets (Currencies, Bonds, Stocks) Discount Information Near Simultaneously
It isn’t only currency markets that move fast. All sufficiently liquid markets discount widely known information near immediately—so you can’t use wiggles in one market to predict another market, something we see done quite widely. Last year, folks commonly presumed the strong dollar would eventually sink stocks. Or that falling oil process would eventually wreak havoc. This year, many presume stocks are blissfully overlooking weak high-yield bond prices. Generally speaking, though, if one liquid market reflects a trend, you can be fairly sure other liquid markets know about it. To illustrate this, Exhibit 3 is the same as Exhibit 2, but it adds the Euro Stoxx 50 Index—a euro-currency denominated gauge of large European firms. The magnitudes aren’t important here—note the near-simultaneous movements.
Exhibit 3: Minute-by-Minute Tick of Euro Stoxx 50 Index and USD/EUR Exchange Rate, 12/3/2015
Source: FactSet, as of 12/4/2015. Intraday prices and exchange rate, 12/3/2015. Times are in Pacific Standard Time, as this is the applicable zone where the author is sitting.
Lesson #4: Relative Exchange Rate Fluctuations Do Not Materially Impact Inflation Rates.
Pundits often presume a weak currency means inflation is soon to arrive, as imports will cost more, and vice versa. Hence, many refer to policies that weaken a currency as “importing inflation” (flipside: exporting deflation). Yet in their comments, both Fed head Janet Yellen and Draghi noted inflation is presently lower than their targets. And it has been persistently, despite vast differences in their currencies’ moves. Heck, inflation is low across the developed world—lower in Europe than the US, even though the euro has been very weak against the dollar for more than a year. And we are talking about core inflation here, not headline. This isn’t a facet of oil prices, which we realize are skewing many price measures.
This is not to say there is no impact—just a much smaller one than many presume. Always remember: Inflation is a monetary phenomenon—it’s about how much of the currency is coursing through the economy. Too much and you’ll get inflation—too little will likely bring deflation. Currencies, however, are always valued in pairs—they are by definition relative. The dollar is only strong or weak as compared to another currency (or basket of currencies).
Lesson #5: “Divergent Monetary Policy” Doesn’t Automatically Equal a Surging Dollar.
With the ECB theoretically “easing” policy while many presume a Fed rate hike is coming, the pages of the financial press have been packed with claims that central banks moving in opposite directions means the dollar will surge further, wreaking havoc on exporters.[ii] However, history suggests the impact isn’t that direct—perhaps, again, tied to Lesson #1.
In 1994, Germany’s central bank (the Bundesbank) and the US Federal Reserve entered a period of extremely divergent rates, as the Fed began a rate hike cycle while the Bundesbank was cutting. From the beginning of 1994 until the end of the Fed’s hike cycle in July 1995, the Fed boosted the fed-funds target rate from 3% to 6%. Meanwhile, the Bundesbank cut the lower end of its overnight policy rate range (the discount rate) from 5.75% to 4.00%. Netting the two, US target overnight interest rates rose 4.75% versus Germany’s.
If the conventional, “divergent policy means strong dollar” logic applied, the US dollar should have surged against the German deutschmark. But it actually weakened throughout the cycle. Exhibit 4 shows this period of divergent policy and the weak dollar against the deutschmark.
Exhibit 4: Divergence Doesn’t Automatically Mean Dollar Strength – 1994/5
Source: Global Financial Data, FactSet, as of 12/4/2015.
Markets can be counterintuitive, frustrating beasts indeed. But we believe you’ll better grasp how markets operate if you can internalize these five lessons.
[i] While we believe attempting to game the Fed is fallacious and an impossible task, not all market participants agree. Many do attempt to divine what the Fed will do. Some strength in the dollar in the last year is likely tied to this very gaming.
[ii] Prior to 2008, when central banks around the world coordinated policy actions, monetary decisions often conflicted. This was not called divergence, it was called, “normal monetary policy,” and that is still what it is.