Monday, May 25, 2009

Invisible Hands that 'Step In'

Hans Wagner at Daily Markets writes on ‘Bond Yield Curve And The Stock Market’ HERE:

In theory, rising interest rates should be good for stocks. Rates tend to rise when the economy is recovering from a down turn. However, higher rates can also be a determent to an economy that is recovering. That is why the Federal Reserve is keeping short-term rates near zero. However, controlling long-term rates is much more difficult. The hidden hand of Adam Smith steps in and forces all entities to deal with the realities of economics.

When rates go up, many investors seeking safety, who had been buying stocks, opt for bonds to receive their yields tempting. When investors perceive they can get better returns from long-term bonds than from stocks it takes money out of the stock market. This tends to put downward pressure on stocks prices. In addition, companies that sell long-term debt will pay more now that rates are higher. This reduces their earnings power

Hans Wagner writes a clear, concise, and accurate account of the Bond Yield Curve, accepting that the BYC is a possible prediction; more of a guide from the past for possible, but uncertain, future behaviour.

The authorities can attempt to influence future behavour by manipulating current and future yields, which may have a desired affect or may meet with stubborn resistance as opinions diverge and losses mount for some.

What investors in stocks and bonds do in their anticipations of the future is down to their usual perceptions of risks. Here, Hans employs a metaphor to skate over the effects of investors’ judgements: ‘The hidden hand of Adam Smith steps in and forces all entities to deal with the realities of economics.’

He does not explain how an ‘invisible hand’ is able to ‘step in’ (more a role for a foot). In practice investors do what their degree of risk avoidance influences them to do. The ‘realities of economics’ are not read from a textbook - more likely from professional advisors angling for commissions to advise them or subscriptions to their newletters – and opinions may differ about the ‘realities’ of ‘economics’.

In short, if investors follow the advice or their best guess and behave according to the Bond Yield Curve’s predictions of future yields, assuming they find and trade with others offering contracts carrying interest rates according to their fancies, and assuming these prove profitable in practice, then Hans would ascribe their behaviour to ‘the invisible hand’ with a ‘foot’ attached. Of the others – there are always others – who behave differently, they have shrugged off the ‘invisible hand’ and have side-stepped its ‘foot’.

Why not say so, by explaining the role of the yield on the risk perception of investors, as identified by changing interest rates on short and longer term bonds compared to alternative perceptions of earnings from future share prices?

If stuck, try admitting that its all down to differences of opinions, backed by trades in shares and bonds? Of course, for a professional advisor to admit that what people do is respond to changing prices and yields would hardly be worth a fee or commission, or the price of a publication.

That’s where a widely shared quasi-religious belief in invisible hands ‘step in’ to obfuscate behind a veil of ignorance and a multitude of opinions. It's the difference of opinions that makes the market in shares and bonds (acknowlegements to the American author who said something similar about horse racing, but whose name I have forgetten this morning).



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