Economists pay insufficient attention to asset prices. Ask most economists what the relevance of the bond equity correlation is for fiscal policy and they will be baffled. You’ll be lucky if they know what you’re talking about. The bond equity correlation is the observable relationship between government bonds and stock prices. Do stock prices rise or fall when bond yields rise? A negative correlation implies that stock prices fall when bond prices rise (and yields fall). Why should economists care? This statistic is nothing less than the indicator of whether or not a country can engage in counter-cyclical fiscal policy. It is far more important, for example, than the fact that the dollar is a reserve currency.
This is worth unpacking because a fresh debate is emerging over the constraints on fiscal policy – particularly as the more enlightened parts of the political world realise that the status quo is untenable, and resisting destructive nationalism, requires more radical and meaningful intervention than we have seen for several decades. The bond equity correlation is in fact at the heart of how we can finance our ambitions.
How so? Let’s start with the stock market side of the equation. Stock markets are a measure of recession risk. They are not predictors of recessions, as such. Paul Samuelson famously quipped that the stock market has predicted seven of the last three recessions – or words to that effect. But the joke is only partly insightful. Yes, there is excess volatility in stock prices for a host of reasons, but the probability of recession fluctuates, so stock prices should fluctuate with these probabilities. In that sense, the stock market should ‘predict’ more recessions than actually occur.
The correlation properties of stock markets reveal more than their predictive powers. Correlation with news and the prices of other assets reveals how the world works, prediction is for astrologers. The critical point is that stock markets fall in recessions, and consequently stock prices are affected by perceptions of recession probability. The precise reasons *why* stock markets fall in recessions are not totally clear, but as an empirical observation it is also very robust. Whenever there has been a significant contraction in US GDP, for example, the major stock market indices have fallen by at least 50%. The obvious explanation is that stock prices are the present value of profits, and aggregate profits are highly cyclical. This is less convincing than at first blush. Why, for example, should a pension fund holding stocks care about a one- or two-year decline in profits, when the capital stock has enduring value? To explain the extent of stock market declines in recession we probably also need to draw on financing constraints, political and behavioural factors. Household and corporate cash flows fall during recessions, probabilities of default rise, political risk rises – often threatening property rights – and behavioural fear and myopia abounds. Every recession propagates the fear of depression.
So stock prices fall in recessions. That is one side of the equation. What do bonds do? And what does all this tell us about the viability of counter-cyclical fiscal policy, and the neutral policy rate?
Government bonds are not as predictable as stocks, or at least their properties are more dependent on the prevailing macroeconomic regime. How bonds behave during recessions depends on what inflation does, and in contrast to profits – which always fall in recessions – there can be recessions which cause falling inflation (the GFC), and recessions which coincide with higher inflation (such as Turkey, currently). Turkish bond yields have risen with recession risk because the central bank has to raise interest rates to stabilise the exchange rate and contain the rising inflation. This is the definition of an ‘emerging market’, or a 1970s developed market.
So if stock prices fall in recessions and bond yields can either rise or fall, the bond equity correlation is the key. It tells us what to expect bond yields to do if recession strikes. If bonds and equities are negatively correlated, expect bond yields to fall in a recession. It is this which signals the viability of counter-cyclical fiscal policy. This should be obvious, because the bond yield is the cost of government finance. A negative bond equity correlation implies that the governments cost of finance falls in recessions which frees it to counteract the opposite force in the private sector reflected in the rising cost of equity.
There has been renewed debate about optimal fiscal rules and the constraints on government borrowing, most recently because Olivier Blanchard has thought through the consequences of government bond yields sitting below nominal growth in most of the developed world (Olivier – this has been the case for more than twenty years in post-crisis Asia!). And some strident literalist functional finance addicts have pointed out that if the state can print money, inflation is the ultimate constraint on the fiscal authorities – whatever ‘ultimate’ means, and assuming the state, the monetary authority, and the fiscal authority are one, which they are not! This is all good intellectual fun, but back in the real world, we collectively decided a long time ago to put checks on the power of elected politicians in macroeconomic policy-making and give central banks varying degrees of autonomy in controlling monetary policy via official interest rates. The practical constraint on fiscal policy is therefore not inflation, but the central bank raising interest rates. Trumpanomics is a controlled experiment: if you aggressively ease fiscal policy when the economy is close to full employment, the central bank will raise interest rates and bond yields will rise.
This leads us to the how the equity market determines the ‘neutral policy rate’. I have argued in the past that we need to get away from the idea of some magic level of the interest rate that somehow brings inflation to 2% and the economy to full employment. It is not just that such an equilibrium interest rate may be hard to determine, it simply may not exist. I have also suggest a view of how the economy works, where the system in fact adapts through time to the prevailing level of rates – keep interest rates at or around a given level for long enough and it will probably become the ‘equilibrium’. I have also engaged in a series of debates and discussions with the effects of rates on the economy more broadly. The standard New Keynesian view of how interest rates affects consumption and investment – which is in part a classical, micro-founded view – has validity and great conceptual value, but also some huge flaws – not least that the corporate sector does not finance itself using the policy rate (which is acknowledged in the models, but rarely in policy discussions), and the consumption Euler equation has lots of problems. Similarly, I have engaged with neo-fisherists, who argue that raising rates raises inflation. In summary, my own view is that the significance of the policy rate is wildly exaggerated and its sign and significance is not linear. It is entirely plausible to me, that moving from zero to -0.5% interest rates might worsen economic conditions, articulacy if the primary effect is to damage the profitability of banks. Similarly, citing real interest rates in Brazil, where they are high, can trigger a boom in durable goods spending.
So what bearing do equity prices have on this debate? They provide a very useful short-cut for policy makers. The cliche of the ‘Greenspan put’ had it the wrong way around. The Fed’s job is not to ‘bailout’ equity investors. Nor is it the case that equity prices ‘predict’ recessions with seer-like accuracy, or that falling stock prices cause recessions. No – falling stock prices signal that that a rising policy rate is threatening one. So monetary authorities should take note. Trump stumbles upon a truth.
The recent episode is also instructive in describing the transmission mechanism. As economists we can debate the theoretical and long-sample empirical effects of interest rates, but the facts are quite stark. A rising Fed funds rate and two-year yields appear to have had a very coherent impact on global and US growth. The weakest link is dollar-leveraged emerging markets with large current account deficits. But US stock prices largely ignored the turmoil in Argentina, Brazil and Turkey through the first half of last year. It wasn’t until credit spreads started to widen materially in the third quarter that US stock prices responded. One aspect of the debate on the effects of policy rates on demand, that is often ignored by economists, is default risk. When as economists we consider that the income effects of changes in interest rates should be symmetric and have to rely on different marginal propensities to consume between income earners and payers – an argument Miles Kimball is fond of – we ignore the fact that if rates hit a point where default probabilities rise both borrower and lender are negatively affected. This process completely undermines neo-fisherian pretensions, which seem premised on the assumption that the only entity whose financial growth burden rises with interest rates is the government, which could not be further from the truth, as our bond/equity discussion revealed.
So these observations also have theoretical relevance – equity prices reveal the sign of the impact of the policy rate on demand, and reinforce the view that the sign is not stable. In the early stages of recovery from recession, interest rates and stock prices both rise, because a rising policy rate is a sign of economic strength. Expect this to occur in Europe. It is impossible to know if this is coincidence or causality, or a combination of both. But at a certain juncture policy rates become an independent factor, threaten growth via default risk, the sign changes – and the stock market signals this.