66 J. E.

Silvia

Linkages Between Markets

As we have said, it is not correct to assume that the economy evolves toward a
given equilibrium in the market and rarely achieves an equilibrium given the
multitude of both supply and demand-side shocks. Rather the economy and
financial markets move from one disequilibrium to another. In the markets,
there is seldom insufficient time after a given shock for the economy to have
the luxury of evolving toward an anticipated end point before another shock
moves the path of the economy. Moreover, when we force estimates of the
economy to fit our forecasting biases, we fail to see that economic events have
already moved in a new direction. Complicating the process, our cognitive
biases diminish the importance of new developments since they contradict
the success of our initial forecast. We ignore what is different (normalization
of deviance) and accept what confirms our priors (confirmation bias).

Price Adjustment
We observe that prices do adjust over time but that our four market prices of
primary focus here are characterized by differential speeds of adjustment and
that each market incorporates expectations into its price setting.
In the first half of 2020, the rapid easing of monetary policy in the United
States was accompanied, in the short run, by a rise in the dollar’s value
even as interest rates fell. In part, the U.S. dollar, and the benchmark Trea-
sury 10-year rate offered a flight to safety, given global uncertainty of the
impact of the COVID virus. Expectations were that the U.S. economy would
be more resilient over time than other world economies and that the U.S.
dollar/Treasury note represented a safe harbor. From January 2020 to June
2020 the Chinese Yuan depreciated versus the dollar.
But from mid-June to late August the Yuan appreciated versus the dollar.
Investor expectations had shifted toward a quicker Chinese recovery and a
less pronounced U.S. recovery. America was thrown into a severe shutdown
of business due to state-mandated shutdowns resulting in millions of workers
losing their jobs or on temporary furlough. Meanwhile, the Federal Reserve
sent out signals of persistent easing. The dollar began to decline while U.S.
Treasury rates rose modestly.
In each of our four markets, the rate of price adjustment is a function of
the difference between current and equilibrium prices as well as the gap in
expectations between future values of the current economic benchmarks and
their current levels.
 2 The Story of the Original Boom and Bust … 67

Changes in economic policy, when not publicly known or understood

(Affordable Care Act), or when quickly reversed (monetary policy 2019), can
generate a short-run burst in economic growth and higher inflation/equity
values or exchange rates or a short-run turn in interest rates. After the Fed ease
in mid-2019, NASDAQ share prices rose steadily until early 2020 and two-
year Treasury rates fell for the rest of 2019 as expectations of more Fed easing
and lower rates played into market pricing. The break-even 5-year inflation
rate fell as the Fed easing altered expectations about the pace of growth and
inflation going forward. Once the investing public, expectations will again
match ongoing policy. Changes in economic policy impact expectations and
therefore aggregate demand/supply relationships.
What changed over time? Investors saw that the expected pace of U.S.
growth relative to China was diminished. For them, the longer-run value of
the Yuan appreciated relative to the dollar even though in the short run the
yuan had depreciated. The Yuan had overshot on the downside in early 2020
and the dollar overshot on the upside.
Markets had also overshot on the downside for benchmark Treasury rates.
The low on the benchmark ten-year rate occurred in early March 2020. The
rate has risen since although it remains low relative to recent history. In this
case, expectations of the long-run value of Treasury debt as a safe harbor
have diminished. Spreads on high-yield debt peaked in mid-March and have
declined since. Finally, equity values saw its lows in late March and have set
new records recently.
What do we take away from here?

• Prices do adjust over time.

• The four market prices are characterized by differential speeds of adjust-
ment.
• Each market incorporates expectations into its price setting.

The speed of adjustment of expectations, rate of convergence depends on

the structural parameters/elasticity of each of the factors that determine prices
in each of our four market prices.
For the equity markets, modest changes in policy-set interest rates meant
a much larger response than for the dollar or for overall aggregate demand in
the economy and commodity prices in general. In contrast, housing demand
responded sharply to lower rates while business investment demand had a
very limited response. Commodity prices rose with expectations of better
economic growth but had very little response to lower rates. As expected, the
larger the price elasticity of demand (housing), the more the change in actual
68 J. E. Silvia

interest rate will affect demand, even in a period of overall sharp declines in
GDP growth. As an aside, what made the first half of 2020 unique was that
personal income rose during the recession.

Evolution of Irrationality: Expectations

Overwhelm the Fundamentals
The credit cycle, much like the business cycle, is driven by complex economic
relationships. Understanding the emotional component in these cycles can
equip investors to better identify turning points in the cycle. This is particu-
larly true in situations where expectations overwhelm fundamentals.

Euro Sovereign Debt

Many liquid assets which are close substitutes for money… [are] only inferior
when the actual moment for a payment arrives—Radcliffe Report (1959)

The Report of the Committee on the Working of the Monetary System

(commonly known as The Radcliffe Report) was published in 1959 about
monetary policy and the workings of the Bank of England. Named after its
chairman, Cyril Radcliffe, the report was the result of dissatisfaction with the
monetary policy of the 1950s.
For the committee, the growth of credit rises with euphoria. As animal
spirits take hold, investors seek out opportunities, producing more credit in
the system. The “dot.com” bubble and the subprime housing bubble support
the insight that credit availability and risk grow with prosperity.12 What
makes the current (2020) investment scene so challenging is how to value new
instruments against the central banks’ administered interest rates. Investors
know central bank rates are not normalized, but what do they know of the
anticipated market returns for new investment opportunities?
As illustrated in Fig. 2.9, when the moment of payment arrived in southern
European debt in 2014, liquidity and credit quality became cloudy.13 The

12We shall see in Chapter 5 further evidence of the procyclical nature of credit availability.
13The importance of illiquidity in financial cycles and crisis is discussed in Jean Tirole, “Illiquidity
and All Its Friends,” Journal of Economic Literature, 2011, 49 (2): 287–325.
 2 The Story of the Original Boom and Bust … 69

Long-Term Government Bond Yields: 10-Year,

Percent
14.0

12.0

10.0

8.0

6.0

4.0

2.0

0.0

-2.0

Spain Portugal Italy Germany

Fig. 2.9 Long term government bond yields

expectations of economic harmony faced the reality of divergent fiscal poli-

cies. As a result, bond yield spreads tightened considerably within a very short
period until a further regime change was announced by the ECB.

Net Percent of Banks Tightening Credit

on Commercial & Industrial (C&I) Loans
Credit quality hurdles differ significantly over the business cycle—to empha-
size the issue, these credit benchmarks are very procyclical (Fig. 2.10).
Initially, both a creditor and a debtor start the allocation process with an
apparently economically legitimate project, where risk/return has a sense of
balance. Then, as the first projects demonstrate success, more projects are
financed. As credit becomes more available, unfortunately, the expected rates
of return diminish at the same time. The low-lying fruit has been picked. An
inverse relationship thus exists between demand for C&I loans among firms
and the credit standards required by banks to offer loans. Credit agencies are
aware of the behavior of investors over the business cycle and try to mitigate
credit risk begin tightening standards as demand soars. As illustrated in the
figure below, credit standards tighten going into a recession and peak during
the recession.
70 J. E. Silvia

Net Percent Tighter Credit C&I L L&M

100.0 1
0.9
80.0
0.8
60.0 0.7
0.6
40.0
0.5
20.0
0.4

0.0 0.3
0.2
-20.0
0.1
-40.0 0
1990-04-01

1992-11-01

1995-06-01

1998-01-01

2000-08-01

2003-03-01

2005-10-01

2008-05-01

2010-12-01

2013-07-01

2016-02-01

2018-09-01
Recession Net Percent Tighter Credit C&I L L&M

Fig. 2.10 Net percent of banks tightening credit-business loans

Shifting Investor Motivations: From Income

to Capital Gains
For J.P. Morgan, the success of the railroads depended on traffic flow. When
he looked at the railroad industry, he saw that it was badly overbuilt and
consolidated and reorganized railroads—notably the Philadelphia & Reading
as well as the Chesapeake & Ohio. But for Jay Cooke, who is credited as being
the first major investment banker in the United States, the key to financial
success was different from the sale of railroad bonds to European investors
with limited knowledge of American geography.
Until 2005, for many American households, the income earned from
owning a home had the psychic benefit of safety and place. That year flipping
houses and capital gains became the rage. Higher prices lead to expectations
of even higher prices—the demand curve sloped upward, and the boom/bust
was on. Anchoring home values to fundamentals was gone. The recency bias
took off.
 2 The Story of the Original Boom and Bust … 71

Credit Today, Payments Tomorrow

On what basis is credit advanced? At the start of many innovations, credit is

advanced in anticipation of an income flow to pay off that credit. The initial
investors often get their return based upon actual economic income returns.
As time moves on, credit is advanced to realize capital gains. These gains
are less available as the obvious winners are chosen first and then projects with
less expected returns follow. This phenomenon is represented in Fig. 2.11,
which depicts the run-up in home prices in the mid-2000s. Many individuals
believed home prices could not fall and treated the homes as an investment
opportunity with little downside. What former Fed chair Alan Greenspan
dubbed “Irrational exuberance” became coupled with the decisions of inexpe-
rienced investors. This pattern also reflects the cognitive bias of normalization

S&P/Case-Shiller U.S. Home Price Index

300.00

250.00

200.00

150.00

100.00

50.00

0.00

Cleveland Las Vegas National Tampa

Fig. 2.11 Housing price cycle last thirty years