Earlier this summer, David Lucca and Emanuel Moench, two economists at the NY Federal Reserve, reported that “since 1994, more than 80% of the equity premium on US stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee (FOMC) announcements.” Per Lucca and Moench, without this phenomena, the S&P 500
(^GSPC) would be trading today closer to 600, rather than its current 1400 level.
While on the surface policymakers’ ability to lift nominal asset prices to such heights may appear to be a strength to be celebrated, I am afraid that the front running phenomena suggested by Lucca and Moench raises concern.
Few investor behaviors reflect extreme confidence like front running. Through this act, investors are expressing a high degree of certainty that, in this case, central bankers are not only able and willing to act, but that those actions will be effective in the future. Without all three of these beliefs, investors would instead be far more likely to take a wait-and-see approach.
But with investors now seemingly certain of not only the Federal Reserve’s willingness and ability to act but also the effectiveness of those actions, policymakers face the unenviable task of ensuring that all three dimensions necessary for front running remain intact. Two out of three components are not sufficient. And, needless to say, perceived divisions among Fed governors or perceived reductions in Fed independence could wreak havoc on investors’ continued willingness to front run FOMC meetings.
But I think there may be a far more important element to this front running equation that policymakers need to consider, and that is how it reflects investors’ own level of confidence in the first place.
Weak confidence naturally lessens risk taking. Worse, it erodes our faith in others. It is no coincidence to me that Jim Cramer’s famous “They know nothing!” rant aimed at Federal Reserve policymakers occurred at a major market bottom in August 2007 -- nor that The Economist
magazine cover the week of the major October 2011 bottom warned, “Until politicians actually do something about the world economy... BE AFRAID.”
As our confidence falls, perceptions of uncertainty prevail – including our perceptions of the strength of policymakers.
While some pundits have analogized the Federal Reserve to the Wizard of Oz or the Music Man, I think that David Lucca and Emanuel Moench’s work suggests a far simpler image. When it comes to confidence, we and the Federal Reserve are one. We are confident that the Greenspan and Bernanke “puts” exist when we are confident about our own futures.
As policymakers contemplate the road ahead, they would be wise to focus on investor’s perceptions of the Federal Reserve’s willingness and ability to act and the market’s assessment of the effectiveness of further policy actions. Any reluctance by the market to further front run the FOMC may be an indicator of a much broader overall decline in market confidence. And as confidence goes, so goes the market.
Peter Atwater's groundbreaking book "Moods and Markets" is now available for pre-order on Amazon and Barnes & Noble.
“Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the ‘me, here, and now’ behavioral tendencies of the post-crash world.” —Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation
Position in SH and JPM
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