Looking through the other end of the trade

Revelatory market reactions

One of the persistent errors in modern political commentary is to treat reactions from financial markets as objective verdicts on government policy.

Toby Nangle wrote a great FT piece considering how the Government should relate to the bond market. This has some very helpful corrective insight.

Government bonds of developed markets like the UK or US that issue their own currency record their strongest returns when the economy slumps. Austerity is always at the top of bondholders’ professional wish lists, and bond investors are frenemies at best to a pro-growth chancellor. Putting too much weight on those investors’ opinion would consign the economy to a tepid growth trajectory.

George Osborne defended his austerity programme in parliament as necessary medicine to retain access to bond markets. This was shortly after Bill Gross — then the world’s most famous bond investor — warned that gilts were “resting on a bed of nitroglycerine”. What followed was a lost decade for economic growth. Public sector investment was cut by a quarter in real terms, and day-to-day spending for non-protected departments plummeted. Both economic productivity and living standards near-flatlined.

But bond investors cheered…

It now looks almost certain that the country’s faulty fiscal rules will be tweaked — perhaps substantially. Doing so will create somewhere between £7bn and £60bn of fiscal headroom depending on the new measure, giving the chancellor greater capacity to fulfil her pledge to “invest, invest, invest”. Such plans will never be welcomed by the bond market. This is partly because more public investment is likely to mean a greater supply of gilts. But it is mostly because more investment will boost economic growth. This is anathema to bond investors. Paradoxically, such an acceleration is exactly what Britain needs if it is to move on to the path to long-term fiscal sustainability — a cause that they like to champion.

I personally find it rather maddening when political commentators seem to have internalised a view that bond or other financial market reactions encompass an objective or neutral assessment of any given development. Yes investors have skin in the game, which should mean they try and make informed and accurate decisions. But they have skin in the game as investors. Market reactions represent a relatively short-term perspective on what developments mean for investors. What is good for investors can align with what is good for everyone, but it does not always do so.

For me, Toby’s piece nails this in relation to the bond market. What might be good for the UK in the medium to long term might be considered bad for bond market participants in the short term. A negative market reaction is not in and of itself any kind of verdict on whether or not the government is doing the right thing. I think / hope most people understand this at a fundamental level but it does seem to get forgotten in the heat of the moment.

I see something similar at play in equity markets. There are some clear examples where share prices have fallen or risen in response to developments relating to the workforces of particular companies. The example of Prop 22 in the US - which, to simplify, meant workers did not have to be classified as employee - is illustrative. When Prop 22 initially passed, the shares of Uber, Lyft etc surged. When it looked to be reversed they fell. And when Prop 22 was upheld they rose again.

The share price rises do not mean, or prove, that Prop 22 passing and subsequently being upheld was an inherently good thing. They show that investors considered that this outcome would be better for investors. We can even flip the logic here and infer that the market reaction was telling us that the outcome was bad for workers. And going a step further, the scale of the moves hint at the value of the rights that workers would have had if the rulings had gone the other way.

It’s not clear cut. In the Prop 22 example one could argue that negative market reactions were in part due to a belief that greater employment rights = higher costs = higher fares = less rides taken overall. I’m not sure that is really what was going on, or at least not the dominant factor, but something to bear in mind.

However, the broader point stands. Market movements should not be considered neutral verdicts from referees - they are reactions from interested players. In certain cases negative market reactions might signal an important, justified advance for other stakeholders. A sell-off can be the price of progress. And similarly a market rally might reveal the quantum of exploitation.