With key central bank policy rates stuck at the zero bound (or below!), investors in Europe, Japan, and the United States are searching for yield under every rock (see, for example, the charts below on S&P500 prices and earnings). That is, they are willing to accept small gains on their investments because they see little risk that their cost of funding will rise significantly for a long time.
S&P500: Inflation-adjusted Stock Prices and Earnings, 1871-June 2014
S&P500: Cyclically-Adjusted Price Earnings Ratio (Average 10-year earnings), 1881-June 2014
This poses a familiar question: What to do when the prices of assets rise above what history and fundamentals warrant?
There is an enormous asymmetry built into capital markets. If you think that prices are too low, you can buy. But if you think prices are too high, what should you do? One option is to sell short – borrow the security whose price you believe to be inflated, sell it and wait. But short sellers are often vilified as trying to benefit from the failure of others. And, adding injury to insult, it is a dangerous business. The danger arises from the fact that a short-seller has to post margin to ensure they can make good on your promise to return the shares or bonds. If prices climb higher for a while, as typically occurs in asset price bubbles, then the short-seller will have to come up with additional margin. And, if prices rise enough so that the margin call cannot be met, the investor may be forced to sell the position at what could be a catastrophic loss.
Divining correctly that prices will eventually fall is no protection. As Keynes is reported to have said “Markets can remain irrational longer than you can remain solvent.” Modern econ-lingo calls this “the limits of arbitrage.” The classic example of these limits is the funding crisis of LTCM, a large hedge fund that nearly collapsed in 1998 when a number of leveraged “arbitrage” trades which were sure to pay off over time temporarily went in the opposite direction in a synchronized fashion.
Even with their long time horizons and deep pockets, policymakers face a similar asymmetry. It’s true that for a central bank, liquidity isn’t tied to solvency, so experiencing temporary losses is more a political than an economic or operational concern. But losses still matter. And some short sales – however useful for containing an asset bubble – are simply inconsistent with other policy goals.
Buying assets that are perceived to be undervalued poses no technical obstacles (as central bankers would say). There are numerous examples of central banks purchasing assets in an effort to push prices up. These include the Hong Kong Monetary Authority’s purchases of equities in August 1998, the Bank of England’s acquisitions of commercial paper and corporate bonds through its Asset Purchase Facility starting in January 2009, and the ECB’s buying of securities that meet the requirements of its refinancing operations beginning in May 2010. The Federal Reserve’s massive purchases of mortgage-backed securities also fit in this category.
But what is a policymaker, even one with a very long horizon and very deep pockets, to do if they believe assets are overvalued? On occasion, central banks have gone into currency futures markets in an attempt to keep their exchange rate from depreciating. Or, as in the case of the Swiss National Bank, they have sold their currency without limit to keep it from appreciating further.
However, short selling can create both technical and political problems. Consider, for example, the dilemma for the central banks of the euro area, either the ECB or the National Central Banks, should they judge that Greek bank equity prices were far too high. Could they sell these stocks short? No way! Doing so would almost certainly trigger a renewed bank run out of Greece (and possibly other peripheral economies), undermining the goal of financial stability that also is key in the current environment to securing price stability.
Sometimes policymakers are trapped in the box that they built. In the euro area, It is precisely investors’ belief in the commitment of authorities to monetary and banking union that makes them willing to view some very risky investments so casually. However, when many such investments are made over an extended period without adequate compensation for risk, sharp investors expect a round of bubble trouble on the horizon.