The financial and economic markets are inextricably interconnected. Understanding these relationships of cause and effect and what market equilibriums are needed to get a sense of where markets are likely to go.
The financial system is what gives real economy money and credit. Money (with which payments are settled) and credit (pledge to pay in the future) are the means of payment that facilitate expenditures. In turn, spending changes to demand and prices.
Economic movements and financial-market movements are a continuous process by which they work towards finding their points of balance. These movements reflect adjustments in goods, services, commodities, and financial assets supply and demand.
High yield rates don’t stay very long. Competition raises profits. If something is very profitable, it will produce more of it, lowering the return forwards.
If making the good is unprofitable, it will produce less until it is profitable. This type of process will start resembling a cycle quickly.
Broadly speaking, there are three main market equilibrium points that need to be reached at the macroeconomic level.
There are also two forms of policies that governments can use to achieve these goals-monetary policy and fiscal policy.
Looking at these forms of market equilibriums and what policy choices need to be made to achieve these, it is possible to estimate what will happen next, both economically and within the financial markets.
Let’s go through these individual market equilibriums:
1. The utilization of economic resources can not be either too high or too small
If there is a lot of slack in the system — e.g. unemployed workers, idle resources like factories — then central banks and other policymakers would have great opportunities to ease monetary policy in order to restore utilization efficiency. This is often called a ‘gap in output’
If the pieces are not properly used within the program, economic activity is bogged down below its capacity. This means that there is likely to be more money and credit being pushed into the system through various means to get them allocated.
Central banks will be inclined to ease monetary policy by some combination of lower interest rates, buying assets (to lower rates further on the curve) or, eventually likely, more directly participating in spending programs. We’ve seen that with joint fiscal and monetary policy responses during the Covid-19 pandemic.
The specific laws and regulatory requirements that central banks have to abide by vary by jurisdiction for different programmes. But a cornerstone is the policy of easing or tightening up to promote or limit credit formation.
Policymakers would be prone to fiscal easing. That can mean a variety of things from government spending programs to tax cuts to deregulation and structural legal reforms and so on.
Prices in the economy and markets will adjust down until spare capacity is again profitable.
On the other hand, when the labor market becomes tight and spare capacity is limited, then there are price pressures in the economy which can lead to inefficiencies, such as prices that go well above wages. Inflation is always exacerbated in something because of a supply shortage of anything relative to demand.
When inflation heats up, or there is the risk that inflation will run too fast, central banks will take steps to curb growth in demand by tightening credit conditions (usually by increasing interest rates).
2. Growth in debt servicing payments needs to remain below income growth
Recessions, at least those in reserve currency countries where shocks related to product and currency are rare, arise when the cost of debt servicing exceeds revenue growth.
Borrowers default, which decreases purchasing power, which decreases income (i.e., dropping asset prices). That leads to job cuts and a reduction in recruiting, which reduces revenue.
That situation must be rectified by central banks. Lowing interest rates in normal circumstances solves the problem. Growth in debt servicing is slipping below the rate of growth in sales, and the trend repeats itself.
Debt is not a question in itself and should not be spoken of in a black-and-white way. There is strong growth in debt and the rise of poor debt.
If the debt is used in a way that produces more cash inflow (i.e., return on investment) than cash outflow (i.e., debt service payments), both parties involved – the borrower and the lender – will benefit nettly.
When the reverse is true, and the cash outflow starts to surpass the generated cash flow. This means that the debt is not being used productively. That represents an unsustainable condition and denotes the need to make changes.
Credit growth needs to take place in a way that achieves balance – when the arrangement benefits both debtors and creditors.
If credit creation is too slow then it will be too slow to spend and invest in the economy. And the economy will not reach its full capacity.
At the other hand, if credit production is running at a rate too fast – that is, if debt growth exceeds income – then the demand level in the economy would be too fast. In the end, debt problems will follow.
For this reason, debt growth must be properly balanced with revenue growth.
In addition, the sales are unpredictable. It is also difficult to reliably determine the amount of income that is specifically sufficient at any given point in time to satisfy debt servicing requirements.
This is why it is important to have the savings available to act as a buffer to deal with any shocks that reduce income. This was particularly important during the shock at Covid-19.
That means savings that are easily accessible at the household level, such as cash and cash-like securities. This means providing ample liquidity for companies to continue operations and to prevent over-leveraging. For countries, this means having sources of strategic reserves to deal with shocks or prospective shortfalls in important goods. For example, foreign exchange reserves, adequate commodity reserves (the major ones being oil, gas, and petroleum). Having a reserve currency is especially important at the sovereign level, as you can create more to fill the income and credit gaps.
Debt development always exceeds revenue because people extrapolate the past. And expect the future to be somewhat close to the world in which they are familiar.
In order to prevent this issue, debtors, creditors, investors, and policymakers need to figure out what kind of return they are likely to achieve. This is by knowing the project or investment and the relationships of cause and effect that drive their interest and potential returns. It deals with the capital markets and is the focus of the next point of balance.
3. Cash must yield less bonds, which must yield less than equity and with the appropriate risk premiums
The expected cash return must be below expected bond returns, which must be below expected equity returns. The appropriate risk premiums must also reflect those spreads.
A risk premium is an expected additional return on investing in something. Determined by duration, credit risk, liquidity risk, and other sentimental and behavioral inputs.
When selecting a stock over most types of bonds, you expect to be compensated for taking correspondingly higher risk.
When these premiums are out of line for long periods, the capital markets can not function very well. It will prevent well being invested and financed by households, businesses and governments.
That’s part of what yield curve inversion gets at and why when it happens, it’s talked about.
When a yield curve inverts, the return on debt is lower than the return on short-term rates. (i.e., cash payable rate or currency-like instrument).
That throws a wrench into the relationship between lender and borrower. If financial intermediaries’ costs are below the rate at which they can profitably lend, they will often choose not to. This slows credit creation and economic growth.
This usually interferes with the opportunities to spend, grow, lend, and borrow when these risk premiums are not there.
Economies work, because people are trading things they have for things they need or want.
The same is true in the markets. Investors will want to be compensated with riskier assets for taking on more risk. It is not attractive to take on these risks if there is not enough compensation involved.
The size of the relative risk premiums will work heavily to assess which capital is going to which properties. This in turn would work to push liquidity and credit all over the financial system and economy. Financial intermediaries, like banks, still try to get this spread.
It makes it unlikely that fluctuations in such premiums would last for long periods of time. This in turn drives returns of asset classes and economic knock-on effects, such as credit and growth in output.
In the economic system in which we live – in developed markets at least, by and large – the financing cost of one person is the return of another. That process is heavily controlled by the central bank of a country or jurisdiction.
We set the rate to cash (also generally referred to as a reserve rate, rate of deposit, or overnight rate). Through the commercial banking system , the central bank makes this cash available to those who can borrow it and generate a return beyond what they will be paying in interest.
The amount of borrowing and lending would also be too high or too low if the risk premium between cash and shares and bonds and stocks is too high or too low.
Tight spreads between asset classes will result in insufficient activity on borrowing and lending. Wide spreads are going to result in too much.
Typically, short-term interest rates on both bonds and equities are below the return rate – or, more generally, riskier, longer-term assets. This encourages people to borrow at the short-term rate to purchase longer-term assets to profit from this spread. These investments may be capital building ventures like factories or industrial machinery, real estate, and conventional investments in financial assets such as equities, venture capital, or private equity.
Below is the relationship between US Treasury bill (a cash proxy) for 3 months and US Treasury bond for 10 years. This tends to invert immediately before recession.
Below is a depiction of how stocks are priced in relation to cash and different types of equity. Cash is compared to the 10-year US.
Below is the return between BB ‘s effective yields (first high-yield loan level) and BBB ‘s effective yields (last investment-grade loan level). At the moment this is just 66bps, which is close compared to BB’s excess risks over BBB credit.
These assets will tend to go up in price because of the leveraging factor and reward those who take on the risk. It triggers an appreciation of the asset prices.
Earnings then go up , making businesses and consumers more creditworthy. This promotes more borrowing and further pushes up asset prices, and lowers these risk premiums. Long positions are increasingly being leveraged in the financial assets.
Usually the central bank will raise interest rates at a certain point to cool off this process, often taking signs from a tightening labor market and/or consumer price increases.
If the cash rate is raised above projected bond yields and/or projected stock returns, this would reward investors for holding on to cash compared to riskier alternatives. The lending and borrowing activity will therefore slow, and the economy will develop at a slower rate.
These positive risk premiums for equity over bonds and bonds over cash normally hold true. This isn’t always going to be true though. Moreover, for that to be the case is not always prudent.
If cash prices were left indefinitely below other asset class returns, then risk-taking would get out of hand. Citizens wouldn’t be afraid to borrow cash and own higher-return assets to the full extent they could, if they thought it would all work. That would not be a set of conditions that are sustainable. Too much leverage will build up in the system and a healthy fear of risk is necessary for investors.
When the US yield curve inverted in 2019 – both spreading the 3-month/10-year and spreading the 2-year/10-year spread later – many market participants criticized the Federal Reserve as indifferent to it. While the Fed was behind the curve and made a mistake in its assumptions of how much and how quickly it might tighten monetary policy in Q4 2018, it is not necessarily the right thing to do to manage monetary policy for stock and/or bond markets.
Having periodic cycles in which risk premiums run close to each other or even become negative helps avoid excessive risk-taking and prevents the economy from running too long over capacity (which leads to future debt problems).
This means that there will be occasional times when both the economy and markets are not performing as well. Where this happens, central banks have a large amount of control, just as they have reasonable authority over when times are better for the economy and markets. Through using monetary policy, they affect the spreads. One such period was Q4 2018.
Tying together these market equilibriums
Those factors are:
1) balancing the economic demand and capacity;
2) holding debt growth (more appropriate, debt servicing bonds) in line with production and revenue growth;
3) Retention of the risk premiums on the capital markets between different asset classes
… are constantly fluctuating above and below their equilibrium levels, often resembling cycles and elongated economic and financial market trends.
They also work synchronously with these business equilibriums. When one equilibrium is achieved, another also gets out of whack.
For example, when risk premiums contract between financial assets and go negative, that often means the economy reaches a point where economic demand and capability are in balance. That’s why you see strong economies accompanied by falling stock prices on occasion. The economies are driven by the financial markets.
When debt growth is brought back in line with income growth, this often means that demand is inadequate relative to efficiency, and risk premiums are too high (i.e. , low asset prices).
Over long periods, such market equilibriums do not stay out of order. If they do, circumstances arise that shift drives back to them. For example, when they are not at their correct points – for example, capital and labor are not utilized properly – this also causes social turmoil and shifts in political regimes.
In the late 1920s and early 1930s, when the US was in the Great Depression, there wasn’t enough stimulation brought to the economy. It has exacerbated the crisis, stocks have lost 89 percent of their value from peak to low, unemployment has been very strong and populism has grown fast.
This culminated in the election of populist leader Franklin Roosevelt, in which currency devaluation policies and unorthodox central bank interventions (i.e., US Treasury bonds bought by the Federal Reserve, just like what quantitative easing (QE) is today) were pursued to address the imbalances. This brings us on to the next section.
Why governments should reach these market equilibriums
Policymakers have two main ways to keep that balance in line, monetary and fiscal policy. Each of us will go through individually.
Money and credit are the two principal ingredients that facilitate changes in spending and economy. Central banks have the ability to control price as well as quantity.
Interest rates represent the price of credit. Interest rates, as generally described, are not the price of money. Money is something that settles a transaction, rather than opening (as credit does) a liability account. Money’s “price” is the opposite of price level, with its value declining due to inflation over time. That’s why cash under the mattress is generally a bad idea or even cash getting an interest rate that doesn’t offset the inflation rate and any interest-bearing taxes paid. Cash may not see it’s value move around a lot so from a volatility perspective it’s considered safe, but it’s the worst investment over time.
This affects the values of financial and real assets, economic activity, and the value of the domestic currency relative to others and relative to alternative wealth store holdings such as gold, as central banks change certain prices and amounts.
Central banks typically do this by purchasing debt assets (to change longer-term interest rates) by changing the short-term interest rate. Firstly, they continue with sovereign bonds as regards asset purchases. Some had gone into corporate credit even before the Covid-19 pandemic, as had the European Central Bank. Bank of Japan and National Bank of Switzerland had gone into equities. The Fed has also now gone into corporate finance and ETFs, owing to the huge decrease in profits owing to the pandemic.
This method operates by inserting cash (liquidity) into the network. In other words , the central bank purchases these securities which reflect assets on their balance sheets. Such debt holders-mainly commercial banks-earn cash (reserves) in return. It influences the differences between assets in the aforementioned ways.
Holders of these bonds would like to buy something similar and step out of the risk curve. It tends to generate an impact on income, which stimulates the economy. The aim is to get it into spending, which helps to support income, which in a virtuous self-perpetuating cycle supports further spending.
Central banks will normally ease policy in this way when economic capacity utilization is low and debt growth is languishing.
That reduces cash rates (short-term interest rates) relative to bond yields. To catch the expanding spread, this spread is captured by investors and financial intermediaries. The bids their prices up and their yields down.
This effect means that spreads will also rise between bonds and equities (i.e., the risk premium will rise). So, at the same time, stocks tend to rise in price.
Because higher prices of assets make people wealthier, they become creditworthier. It promotes more lending and higher spending.
When central banks judge that debt growth is too high, and the economy’s potential exceeds what’s sustainable (such as increasing inflation), they can do the opposite and tighten policy. We will increase interest rates and make their balance sheets run-off or reverse QE.
This makes cash with respect to bonds more attractive and (usually) bonds more attractive with respect to equities. (Equities have a longer length, higher risk of debt than bonds, and can do worse in a-rate setting than bonds if corporate earnings do not keep up in tandem.)
It may cause asset prices to fall or rise less rapidly, depending on the earnings situation and exogenous factors which may influence the day-to-day movement of asset prices.
This in turn makes lending less attractive when rates rise more rapidly than expected returns on investment. Loans and spending would usually slow, allowing economic activity to decrease in tandem as well.
Broadly speaking, monetary policy has three principal forms:
1) Fixing short-term interest rates
2) Acquisitions of assets (also known as “quantitative easing”)
3) Tax and monetary policy general. This could include debt monetization (central bank buys government debt and pays it off effectively) or spending-oriented stimulus (commonly referred to as “helicopter money”). It essentially comes under the popular name of Modern Monetary Theory (MMT), which when addressing fiscal and monetary cooperation is settled into the mainstream.
Interest rate policy impacts the economy widely, and is the preferred method. Rising interest rates make it easier for central banks to buy goods, services and financial assets.
This tends to ease the burden of debt servicing. Lower rates also decrease the discount rates at which cash flows (which form the prices of financial assets) are calculated at present value. That creates an effect on wealth.
We will switch into quantitative easing when short-term interest rates reach zero percent – or whatever lower bound is sought by a central bank, may be marginally positive or a little negative.
They create reserves, a form of monetary savings, and purchase debt and possibly other securities. This growing machine cash and reduces the distribution of returns between cash and bonds. This pushes investors and savers into riskier assets, causing prices to increase to produce an effect on wealth.
Quantitative easing works when the risk premium on debt is high compared to cash and bond equities. It helps to lower the risk more broadly on the financial markets.
When those spreads close it becomes less effective. If the bond spreads are comparable to cash, or provide inadequate coverage for the higher risk level ( e.g., say some period and risk between a Treasury bond and corporate bond), then QE is less efficient. This is because they couldn’t be pushed farther down.
Often this is called “pushing a string” The ability to produce an effect on wealth is diminished, as is the ability to increase expenditure and lending activity, and thus economic output.
If QE is exhausted then they have to turn to a third policy form. No central bank that engages in the activity or has engaged in it in the past (Federal Reserve, ECB, BOJ, SNB) thought they were going through the Covid-19 shock at that point, but they are more or less going through it at the end of their useful life.
We say this because the yield curve spreads far out have largely closed compared to the short-term interest rates. If this distribution closes or comes close to closing it is not relaxing anymore.
The third form of monetary policy that we have now moved into in the developed world could include buying and withdrawing government debt or it could mean putting money directly into the spenders’ hands and tying it to spending incentives. For example, it may vanish after a certain expiration date to incentivize people to spend the money rather than save it.
Joint fiscal and monetary policy can be carried out in different ways in an infinite number of permutations which we discussed in previous papers.
Governments influence the economy through fiscal policy through their expenditure on goods , services, infrastructure, and with policy actions on regulatory and legal reforms and tax policy.
Central banks have a responsibility to determine how much money and credit the system has in it. Federal and local governments help to decide whether to split the pie, whether to redistribute resources through their particular strategies, services, and other acts.
There is a certain amount to be spent on by the governments. They will do this by mixing tax revenue and borrowing. Those options are always unpopular, considering how much to invest, tax and borrow and who gets what collection of goods and services and what institutional changes are achieved, decisions must be made. That process is shaping the economy. Once such choices are made, there will always be those who will benefit and those who will not benefit.
It has a stimulating impact for the economy as governments spend more and/or less on taxes. If the reverse is achieved – spending less, imposing austerity steps and/or spending more – this is economically restrictive.
If the Trump administration passed the 2017 Tax Cuts and Jobs Act (TCJA), this will lower taxes for both individuals and businesses. When you cut taxes, people get to spend more money. When companies retain more of what they earn, they become worth more. That has driven up stock prices and business activity.
The policies which governments also make affect behaviour. This may be labor market laws or regulations that impact on certain economic actors’ performance, security, and protections.
Legal and regulatory changes that eliminate economic activity restrictions will boost the economy, increase efficiency and improve the competitiveness of a country in the world. Fiscal policies can either help or rein in economic activity.
The policies chosen through fiscal and monetary policy may push economies towards or away from these market equilibriums. They can also adjust the velocity at which they move towards or away from them. This can push the economy away from such market equilibriums if policymakers step poorly, incapably, or without adequate haste. If their acts are expedient and necessary, they will move them against the economy and the markets.
You will help to predict what monetary and fiscal policy decisions are likely by seeing which ones are in line and which ones are out of line. When these shifts are anticipated, we can anticipate what the changes in financial market conditions will be.
For where the US and developed market economies are within this template, what kind of policy moves we expect, and what that could mean for markets and certain asset classes coming forward out of the Covid-19 shock, we cover these thoughts in other articles.