Financial Markets and the Economy

Read this chapter to build a foundation for understanding financial markets. The first section discusses the bonds and foreign exchange markets and the way they are connected through the interest rate. The second section builds the model of the money market and connects it to the other financial markets. Pay attention to how the connection is made between the financial markets and the overall economy by showing the effects on the equilibrium real GDP and the price level, using the model of aggregate demand and supply.

The Bond and Foreign Exchange Markets

Case in Point: Bill Gross's Mea Culpa

10.1 case in point

In October 2011, bond fund manager Bill Gross sent out an extraordinary open letter titled "Mea Culpa". He was taking the blame for the poor performance of Pimco Total Return Bond Fund, the huge fund he manages. After years of stellar performance, what had gone wrong?

Earlier in 2011, Mr. Gross announced that he would avoid U.S. Treasury bonds. He assumed that as the U.S. and other countries' economies recovered, interest rates would begin to rise and, hence, U.S. bond prices would fall. When Mr. Gross pulled out of U.S. Treasuries, he used some of the cash to buy other types of debt, such as that of emerging markets. He also held onto some cash. He warned others to shun Treasuries as well.

However, as the financial situation in Europe weakened over worries about government debt in various European countries - starting with Greece and then spilling over to Portugal, Spain, Italy, and others - investors around the world flocked toward Treasuries, pushing Treasury bond prices up. It was a rally that Mr. Gross's customers missed.

From where did the financial investors get the funds to buy Treasuries? In part, these funds were obtained from some of the same types of bonds that were then in the Pimco fund portfolio. As a result, the prices of bonds in the Pimco fund fell.

In the letter, Mr. Gross wrote, "The simple fact is that the portfolio at midyear was positioned for what we call a 'New Normal' developed world economy - 2% real growth and 2% inflation. When growth estimates quickly changed it was obvious that I had misjudged the fly ball: E-CF or for nonbaseball aficionados - error centerfield". In the fall of 2011, he shifted gears and began buying U.S. Treasuries, assuming that a weak global economy would keep interest rates low. He was foiled again, as interest rates started to rise a bit.

In the end, 2011 turned out to be a bad year for the fund, ranking poorly compared to its peers. But after many successful years, it retained its five-star rating by Morningstar in 2012. We must wait to see whether Mr. Gross will get his groove back. In the letter, he concluded, "There is no 'quit' in me or anyone else on the Pimco premises. The early morning and even midnight hours have gone up, not down, to match the increasing complexity of the global financial markets. The competitive fire burns even hotter. I/we respect our competition but we want to squash them each and every day…"