The bond market’s fear of Summers

By Felix Salmon
August 19, 2013

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Well done to Matt Phillips for finding this fantastic photo, by Reuters’s very own Kevin Lamarque, of Larry Summers, wearing his trademark mirthless smile, eyeing the chairman of the Federal Reserve as though he were an appetizer at the Four Seasons. The photo is four years old, but it’s germane right now, because, as Phillips says, markets seem to be freaking out that the man on the left is going to replace the man on the right.

Phillips quotes Julia Coronado of BNP Paribas as saying that a Summers nomination “is starting to get actively priced into markets”, while Morgan Stanley also sees Larry worries behind this chart:

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It’s always hard to prove causality when it comes to market moves, especially ones which happen over the course of a few weeks. Did quantitative easing cause the stock market to rise? Probably, although we can’t know for sure. Did Larry rumors cause the bond market to fall? Maybe — but they certainly can’t account for all of this massive move.

That said, Wall Street unambiguously prefers Janet Yellen to Summers as the next Fed chair, and the bond market in particular is worried that his skepticism about QE will mean that he’ll effectively just go on an extended vacation whenever rates hit zero, coming back only if and when he thinks he should start raising them again.

All of which is to say that Justin Wolfers is wrong when he declares that the market has no preference between Summers and Yellen. He bases his conclusion on the fact that the five-year TIPS spread has barely budged, but he never mentions the huge move in the bond markets, which are much more liquid and therefore more likely to reflect Fed-chair worries.

The market consensus is that Summers would be more aggressive at tapering QE than Yellen, with the result that a Summers Fed would end up spending much less money in the bond markets than a Yellen Fed. That alone would suffice to explain a sell-off in bond prices: you don’t even need any difference in long-term inflation expectations. And if you look at the foreign-exchange markets, it’s abundantly clear that Fed expectations in general, and tapering expectations in particular, are having a very important effect on emerging-market currencies and stock markets.

Still, it’s impossible to disentangle Fed-chair expectations from Fed expectations more generally — and even if it were possible to do that, it would still be impossible to be entirely sure what any particular move in rates meant. After all, the reversion to common sense is probably a good thing, all told — we want markets which look normal, rather than markets which are skewed by zirpy expectations. Theoretically, it’s possible that rates are going up because the markets think Summers will somehow be able to conjure up growth.

The bond markets have moved dramatically over the past couple of months, and no one really knows why. It seems silly to rule out Summers as one of many possible causes — but with any luck we’ve got over our bad Greenspan-era habit of judging the Fed chairman by the movements of markets. The Fed’s biggest and most important job right now is to get a grip on the unemployment rate — something which has pretty much zero correlation with markets.

Still, there does seem to be a decent chance that the markets are sending a signal that (a) Summers is likely to be the next Fed chair, and that (b) they’re not happy about the prospect. Which could set us up for a nice market pop if Obama announces Yellen as the nominee. I’d like that.

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