Author(s): Hyun Song Shin
Date published: Oct 2017
SUERF Policy Note, Issue No 18
Hyun Song Shin, Economic Adviser and Head of Research, Bank for International Settlements
As commentators, we give a lot of weight to market signals. We personify the market and endow it with foresight. So, when nominal yields fail to budge even in the face of impending monetary policy normalisation, we wonder what the market knows that we don’t. It almost seems as if the market is daring central bankers to follow through with their plans.
For the sake of debate, let me offer a heretical thought: what if market signals are not all they are cracked up to be? After all, the market is not a person. Prices are the outcomes of the interaction of many actors, and not the beliefs of any one actor. Speaking of the “market’s expectation” is fine as a shorthand for market prices, but perhaps we fall into the trap of taking the shorthand literally and thinking of the market as a person you can sit down and reason with.
Even as we wrestle with the question of why long-term interest rates do not budge, we know that the bond market can change course quite abruptly. Long rates overreact relative to the benchmark where long rates are the average of expected future short rates. The exact mechanism behind the overreaction varies over time and across markets, but we can sometimes shed light on what is going on without being able to predict when big market moves will happen. I will return to this at the end. In any case, looking out for potential amplification channels for long rates seems more important than ever in the current environment of low option-implied volatility in financial markets.
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