An ‘irrational exuberance’ moment for our times?

James Saft
Reuters columnist
When the bond market and stock market disagree, especially about how to interpret the Federal Reserve, a good rule of thumb is to bet on the side bonds are backing.
That’s what makes the diverging paths of those markets in reaction to Fed Chair Janet Yellen’s unusual comments on market valuations last week so interesting.
“I would highlight that equity market valuations at this point generally are quite high,” Yellen said, speaking at a conference in Washington. “There are potential dangers there … We’ve also seen the compression of spreads on high-yield debt, which certainly looks like a reach for yield type of behaviour.”
In other words, Yellen was pointing out not just that equity markets are richly priced in a historical context but that investors are taking on considerable risks for slim compensation when buying so-called junk debt.
As an ‘irrational exuberance’ moment, Yellen’s intervention was a bit of a damp squib. Equities sold off modestly, by about 0.75 percent, on the day, and government debt more or less ended Wednesday where it began.
Quite a contrast to Alan Greenspan’s 1996 speech when the then Fed chief only needed to rhetorically ask the ‘irrational exuberance’ question to send markets tumbling around the world.
It might be a case of lessons learned. After all, the stock market carried on rising, more than doubling over the following three and a half years under Greenspan’s generous stewardship. So perhaps equity investors are now hard-wired to believe that central bankers are kindly wizards who, possessing few levers to move the economy, are inevitably forced to inflate asset prices to keep things slowly chugging along.
It may turn out that Yellen’s comments not about stocks but about a selloff in government bonds, which she highlighted as another source of risk, were the most significant.
“We need to be attentive to the possibility that when the Fed decides it’s time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates,” she said.
If the market decided that the Fed was going to be forced to raise rates sooner or more sharply than it now believes, investors would demand higher interest rates, incorporating higher term premiums, to hold bonds with longer maturities.
In some respects that might be good news for central bankers. Longer-term interest rates, though they’ve risen sharply in recent weeks, have been exceptionally low, reflecting pessimism about future growth and doubts about the Fed’s ability to kindle even a modicum of inflation.
Caught in a Yellen collar?
In theory higher longer-term rates should be terrible for equities, raising the costs of financing and lowering the present value of any future dividends embedded within a given share of stock.
Yet stock markets sold off only slightly on Yellen’s warning, and rallied hard on Friday’s decent job figures, likely because investors believe subdued wage growth may give the Fed more leeway to be patient about raising interest rates.
Bond markets, though, are taking a slightly different tack. Yields on 10-year Treasuries fell after the jobs data but have since pushed higher, as they have since late April.
What Yellen may be signalling is that she and her peers are alive to the way in which their actions will be taken by financial markets. Equities seems to see this as an asymmetric insurance policy. On this view the Fed eases if there is a selloff but is largely toothless going the other way.
That might be a mistake, and bond investors seem to have been listening.
New York Fed President William Dudley in April outlined a quite different strategy.
“If financial market conditions do not tighten much in response to higher short-term interest rates, we might have to move more quickly,” said Dudley. “In contrast, if financial conditions tighten unduly, then this will likely cause us to go much more slowly or even to pause for a while.”
Dudley describes a two-way strategy, dubbed by some the Yellen Collar, in which the Fed hikes more if it is ignored by markets, but slows down if a market selloff gets out of hand. That would mean there is two-way risk for financial markets from the Federal Reserve, for perhaps the first time since before the Greenspan era.
So far, it looks as if the bond market believes in this two-way risk but the stock market is not so sure.
Remember, too, that government bonds at such low yields are extremely vulnerable to higher interest rates. A bit of a selloff from these levels could leave investors looking at the kinds of bond losses they’ve not seen in more than a generation.
That would hit stock markets too, and probably leave them considerably lower even if the Fed started making reassuring noises.