By Terry Connelly, dean emeritus of the Ageno School of Business at Golden Gate University
Back in the day when he served as the unofficial Cajun spokesman for the Clinton administration, James Carville followed up his dictum about the primordial political importance of the economy with the observation that, given a second life, he would come back as the bond market because then everyone would dance to his tune.
Given a second chance to comment on today's world order, he would likely choose instead to return as the stock market.
Bonds Are Old News
During the Age of Clinton (Wm. J.), Rubin, Gramm and Rudman, the financial world and most of the rest of us did focus intensely on the permutations of U.S. government bond prices to show which way the political winds would have to blow. This was the case whether it was about the Mexican peso crisis or the Long Term Capital Management collapse, or the debates about the Clinton "stimulus package" or tax increases, or whether Greenspan would get the third term Clinton could only dream about.
We had been conditioned in the Age of Henry Kaufman's reign at Salomon Brothers and Tom Wolfe's take on the Masters of the Universe to appreciate the utter centrality of the current price and (inversely, of course, yield) on "Guvvies" to the future of mankind — especially that segment of mankind that lived quite well off dependable interest payment on massive bond holdings (today we call those folks "job creators"), or who were just beginnings to create all sorts of new ways to speculate in debt instruments and "derivatives" thereof (today we call them "plea bargainers").
If the bond market "vigilantes," stirred up by some sort of public or private financial profligacy to play havoc with yield spreads, were somehow persuaded by the Fed or the Congress or the President and his Treasury Secretary that all would be made right for bond traders, then we could all go about our business with normalized and predictable interest rates — Paul Volcker's in his heaven, and all's right with the world.
After the Fall
But then the bond markets, especially their exotic "derivative" forms like credit default swaps and collateralized mortgage debt obligations, got heady with their absolute power and, as Lord Acton suggests, wound up corrupting the whole global financial system, not to mention the U.S. housing market. The weather vane became the hurricane. And since financial markets are essentially a confidence game, where were we to turn when the "Masters" turned out to be the "Bastards" of the Universe?
Of course, the bond markets took the stocks markets of the world right down with them. But when the Fed intervened to cut interest rates effectively to zero to induce at least a weak spark of risk appetite into the Body Financial to buy time and "juice" for the long slog of economic recovery, a funny thing happened to the bond market — it became stunningly irrelevant to folks making political and economic decisions.
Stocks Take Over
With the Fed putting an artificial permanent "buy" order into the market, bond market prices became "distorted" in the view of traders and thus not a true guide to financial market opinion. The Masters had anything to tell us. Instead, all the commentators eyes, ears and noses to the grindstone focused instead on the bond markets wayward cousin, the stock market, to find the way "forward" to what passes for financial rectitude.
The change started back in the Fall of 2008, when the TARP legislation to save the banks and help spare the U.S. a second Depression was first decisively and even somewhat "bi-partisanly" rejected, and the stock market promptly lost about 700 points the same afternoon. Just a few days later, after the Treasury secretary literally genuflected to Speaker Pelosi, TARP was passed and the market moved back to a somewhat more sedate trading range.
After the Obama Stimulus then passed on partisan lines and Obama directly began to talk up the stock market, the Fed got the idea that perhaps its first round of "quantitative easing" in the bond markets could come to its scheduled springtime end. But quick as you can say "Ben Bernanke," just like that the stock market swooned to what turned out to be the lowest levels of Obama's first term, and by the summer the Fed had not only resumed its first QE but also was getting ready to double down with QE II, which sparked the second of what turned out to be several "QE Rallies" in stock prices over the ensuing three years, including the one just before Obama's re-election that followed the Fed's announcement of "QE Infinity." When it comes to getting stocks to move in the right direction, who needs a great convention speech compared with a timely set of Fed Minutes?
No End in Sight?
But the stock market has its own vigilantes now, in the form of hedge fund and other quick action traders who know that a "healthy" stock market "correction" can be very good for them, especially when it has a happy ending — for them, at least. And the famous New Year's "fiscal cliff" doomsday machine that Congress built for itself (and the rest of us) as a sort of shock therapy for its bipolar budget disorder provides just the meal ticket these equity mavens need to both scare the pants off the politicians and set themselves up for some nice gains when the fear of an equity market crash gets into the Washington psyche.
Of special interest is the automatic tax trigger that raises the tax on stock dividends from 15 percent to nearly 43 percent for the highest tax bracket, including more than a few Wall Street traders. Dividends have been a relatively "safe" replacement for bond interest income for many market participants, and the threat for more than doubling the tax to a level equal to the government's take on interest payments sent a palpable shudder through the financial community. The stock market went down 500 points in the two days following Obama's re-election, and was down 1000 points since it pre-election highs until the recent rally sparked by hints of compromise from both the Administration and Congress over tax rate increases.
80 percent of the S&P 500 stocks pay some form of dividend. If you want to see which way the wind is blowing as to the fiscal cliff negotiations, just watch the price of highest-paying dividend stocks.
Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.