BOE,freemarketsandJohnBuchanan

Everyday there are thousands of data points which emerge from all corners of the world which then get assimilated into the traded prices. Some of these are scheduled releases, some are unscheduled, some are sudden, and some are patently unknowable in advance. But the beauty of the markets is that the markets are quick to internalise the surprise element and put forward a price. The price itself is not enough, it has to be a traded one which acknowledges the existence of two parties on opposite sides of the trade with opposite views along with a willingness to bet on those views. This is in essence the genesis of the much-abused phrase called “free market”. We will take a deeper look on that but a bit later, firstly the wrap of the global market news.

Today we will see the release of the NFP report for the month of April in the US. As the US economy continues to reopen, it is expected that the report will indicate an addition of close to 1 million jobs. The corresponding number in March was 916k. The unemployment rate is also expected to go down to 5.8% from 6%. LFPR which is Fed Chief’s favourite muse is also expected to increase as more people start to look out for jobs. The wage growth is also expected to increase. One important piece of news from yesterday came in the form of Bank of England’s policy decision. The benchmark rates were kept low at 0.1% but the key announcement was the reduction on the weekly bond buying program reducing it by 1 bn Pound per week. BOE also raised the growth forecast to 7.25% from 5% for 2021 owing to economic reopening and on a scheduled vaccine roll out. BOE’s hawkish overtures comes close on the heels of what Bank of Canada did a week back where it said that they will be looking raise rates and normalise the policy by end 2022.

Readers would do well to look beyond all these numbers and assimilate the key issue. Economic growth means that you don’t require artificial support and easy monetary policy can be eased. But the tricky part is to know how much of the growth is because of the support. How much of the demand is genuine and how much of it is manufactured? That is why Fed has to keep reassuring that even if the growth and inflation comes back quickly, we have to keep watching it to check whether it is durable in nature.    

Now let’s come back to our discussion of market structure. All the news from Fed, BOE, BOC, NFP adds to information cauldron and the resultant is a price (US yields, Dollar Index, brent crude, we can take our pick). The most fundamental insight of textbook economics is that the price indicates a state of equilibrium where the supply meets the demand. In his book The Forecast physicist John Buchanan delves deeper into this insight and probes it further. As per him the equilibrium can be of two types; one is stable and the other one is unstable (no prizes for guessing).

Buchanan’s departure from the standard thought is that our markets are mostly in a state of unstable equilibrium much more than what we account for. He likens it to a state of weather at a particular place where the current calmness masks how much is happening beneath. The weather conditions can change quickly depending on the currents or directions of waves. A seemingly benign change in underlying conditions can produce a category 5 storm. Buchanan elaborates further by writing that the modern markets can suddenly become illiquid and dislocated owing to small changes elsewhere. Readers would remember that how there was a carnage in US yields markets which impacted the assets worldwide and it was triggered by a lack of demand in one of the treasury auctions. Closer to home we witnessed huge dislocations in cash tom forward swap markets this week owing to increase in Dollar liquidity on the back of an IPO. Long argument short, reasons can come from anywhere, these movements show that the equilibrium is fragile (much more than we account for or accept). Risk managers and decision makers hence would do well to embrace Buchanan’s weather allegory, sunny day today can quickly turn into torrential storm.

Finally, the BOE’s decision to indicate a stance hardening should result in the Pound gaining against the USD or Euro. This will set its own loop, the appreciating currency won’t be music for the exporters. For a country which is negotiating new trade agreements world over, losing competitiveness on the currency front will be a setback. That will prompt the policy makers to act. And the circle would continue, sunshine to rain and back.