Jun 26, 2010

Weekly summary: Stopped out of gold short

I stopped out on the way back up through 1250 today.  It tested down through its 20 day average on Wednesday but didn't stay below for long.  There is some chance the bounce back was expiry related but gold continued higher after the expiration.  Any trapped longs from Monday's breakout have surely been stopped or replaced by stronger hands by now negating one of the drivers for the trade.

The gold rally might get tested in the near-term with the Eurozone fright having past and China resuming currency liberalisation.  I expected a bit more risk seeking this week as markets moved past the fears of a few weeks back but the results were pretty muddled.

  • Bonds are still pressing highs but momentum is ebbing.
  • Gold is similar with early weakness giving way to a weekly close near highs.
  • Equities are heavy but holding recent lows.  It is tough to gauge the impact of the US financial reform debate, with banks trading relatively heavy but wider market moves not reacting to the news flow on that topic.
  • the Australian dollar and Canadian dollar should benefit a lot from stabilising macro news.  Both got dumped more on liquidity than fundamentals when the Euro made lows.  The movements this week support the story that stability is returning but only weakly with movements being a bit lacklustre.  Action in the AUD may be slightly muddled by the Australian leadership change but the big news on that front is probably yet to come as the mining tax negotiations get underway.  

On the Eurozone fright, I don't think I had given enough weight to the idea the Germany could abandon the Euro.  The smaller size of the PIGS, and particularly Greece, made me quickly assume that either Greek debt would be written down or Greece would leave the union.  How can anyone benefit from a currency union where the strong members are encouraged to leave?  Anyway, with the Euro keeping gains and moving up through the week my view may be becoming more mainstream.

On China, it seems like the world is still debating whether the announcement last weekend really means anything (or this).  China is in an odd spot of wanting to dip a toe in with gradual currency movements but knowing that once its intentions clear the market will front run the policy.  This makes timing difficult but ultimately it all appears to be heading toward a stronger yuan and stronger Chinese consumption.  This may uncover some domestic imbalances as it goes forward but near term this also points towards stability.

I also wonder if the traders aren't a bit too negative on the G20.  The view seems to be that either there is nothing to talk about or talks might degenerate into an ugly round of finger pointing.  I expect politicians will err on the side of vague positive statements and keeping disagreements out of the public eye.  Even acknowledging that the world can not return to the pre-2008 configuration of trade and capital flows might be viewed as above expectations.

Jun 22, 2010

Short gold on failed breakout and potential for Chinese yuan appreciation

I sold the August gold contract with a stop near today's peak.   There are a few reasons driving the trade

1) I don't think the movements in gold are widely understood.  I mentioned (on Twitter) Fred Wilson's article on why he thought gold was a poor investment.  Fred was looking at gold as an asset and points out that unlike many other assets its only source of return is price appreciation.  I think this misses the point that gold is more like a currency.  Jim Hamilton reaches a similar conclusion, offering that gold's movements might best be explained by government bond purchasers worrying about the value of the money they are repaid in.

2) The typical reserve currencies - the U.S. dollar, the Japanese yen, and the Euro - all have varying degrees of the same problem.  Their debt levels to GDP are historically high giving them incentive to devalue their currencies.  Typically investors would hedge this risk in other currencies that pay interest rather than gold but there is a worry of policy contagion and likely a need to diversify across many currency options (of which gold is one) to find liquidity with the biggest currencies looking dubious.

Now we are getting to why I would short gold, since the statements above are bullish.

3)  China is a large country with a vibrant economy and excess reserves. It is in some ways the opposite of the traditional reserve currencies with no risk of devaluation to meet debt obligations.  Devaluation risks in China stem from its desire to maintain a weak currency to promote exports.  That policy is probably growing less viable.  They addressed this problem in 2005-2008 by allowing the yuan to appreciate.  That policy of an appreciating yuan is likely to resume now.  The yuan pays interest so to the extent investor can utilise it for hedging purposes it is a better alternative than gold.  This should remove some of the hedging demand in gold.  The yuan revalue may go slowly and may not even go at all but as long as investor access grows, Chinese coupon receipts will win out over gold storage payments.  I expect more news on the Yuan over the next few weeks with the most likely thing being some movement in the daily mid-point. (Update: This has now happened while my this post sat in the editor.)

4) The technical picture and sentiment might make for a swift drop.  Gold's recent new highs, signs of increasing retail ownership, and the obviousness of the money-printing-fiscal-debacle discussed above likely have some leaning the wrong way and speculating on price appreciation rather than just hedging.  I expect the hedge flows are bigger and will dominate the price direction while speculators add to volatility and chase momentum both ways.  The COMEX futures are just above their 20 day exponential moving average as I type and a lower low will occur at 1216.  Either of these levels breaking might be enough to cause the momentum to swing bearish in a hurry.

So to summarise, I see the bullish case for gold but the pressure to use gold as a currency hedge should fall on this Yuan move.  Any further price drop might lead to a sharper and longer term fall as weak hands are shaken out and momentum traders change direction.

Jun 11, 2010

Weekend links: Australian commodity risks, Permabear update, Record GLD holdings, and the Canadian dollar recovers

A few quick links:
Australia's ability to service foreign debt more dependent on strong commodity prices  than housing.  (datadiary.com)
The permabears: where are they now? (Businessweek.com)
Gold holdings of the GLD exchange traded fund reached a record high. (Marketwatch.com)
The Canadian dollar is recovering better than other risk assets. (financialpost.com)
Enjoy the weekend!

Jun 9, 2010

An interesting summary of the May 6th flash crash

This is a very good insiders account of the market microstructure that led to the flash crash and snap rebound.  From an interview with Tradeworx CEO, Naraj Narang:
...So, the market was ripe for a catastrophic event, because it was so saturated with stop orders, all it needed was a catalyst. And the catalyst occurred, according to a couple of Reuters reporters, because a large mutual fund complex, decided to do a $4.5B hedging transaction in e-mini futures contracts, which track the S&P 500 index, when the market was already in that vulnerable state. 
Scott: Most of those were actually transacted on the way up. 
Manoj: Right, but the orders were entered prior to the huge collapse, and that’s the important part. On an ordinary day, an order of that size, and that’s a pretty substantially sized order, would definitely have had a ½% or 1% price impact. But on this day, when volatility was already elevated, and the market was just looking for a reason to take profits, it had an outsize effect, and very likely triggered the first wave of stops, which then turned into market orders, which then led to a gigantic spike in volume. What happened then, in relatively short order, was that the Arca exchange (which is owned by NYSE), fell behind, in terms of its ability to process quotes. Continue reading...

I found it somewhat stunning and slightly amusing that the events above led to a congressional investigation.  Despite all the hand wringing over the "flash crash" it is difficult to view it as more than a distraction for regulators.   These are my reasons:

  • Its impacts were solely in the secondary market.  With every winner producing a loser, it is hard to see any market conspiracy to create such events.  The most obvious way this self-corrects is by increasing traders' preference for limit orders over market orders. 
  • While liquidity gaps don't happen often in large liquid markets like the S&P futures, they should not take anyone by surprise.  The crash of 1987 is referenced above and is an obvious example.  Another more recent example is the gap that occurred in the Japanese Yen in the fall Autumn of 1998 (from 120 down to 112 without trading as I recall) when a large hedge fund asked for a bid to stop out. *
  • The most pressing problem facing regulators is how to identify and react to market dislocations that accumulate over years. Housing prices, the dot.com boom, the Japanese property and equity bubbles in the 1980s...etc.  These market distortions don't focus attention on themselves the way a one day drop does but lead to excess debt and a mis-allocation of resources that reduce growth for years. 
*As an aside, it is interesting that the 1987 S&P crash, the Yen gap, and the 2010 flash crash were all driven by unusually large hedging orders.  When markets make sharp price moves, traders need to make a snap decision about whether the price move represents a signal or just noise.  Usual questions to ask are: 1) How much volume is in the move? 2) Is the seller likely to reverse direction in the near-term? and 3) How many other people are likely to do the same?  A massively out-sized hedging order from a large long-term player following a common strategy will always give the impression that the order is a signal.  In that instance,  men and the machines they build will reach the same conclusion and let prices gap.

Jun 8, 2010

Spanish credit curve beginning to invert

Alphaville points out that the Spanish Credit Default Swap (CDS) curve has joined the Greek and Portuguese curves in inverting.  They explain it as the market pricing in a higher likelihood of default in the early years of the curve.

My explanation would be that the market is expecting a restructuring.  Restructurings tend to haircut the payments due at all maturities by a similar amount.  Thinking in simple terms as if all the debt were zero coupon bullets, a 20% loss on principle expected to be repaid  a year from now is more painful than 20% lost on principle due back 10 years from now.

If investors are beginning to fudge their models to account for principle write-offs they will want to pay lower prices for the short-term debt.  Putting these lower prices back into a standard model that still assumes the full principle repayment will show a higher yield to maturity for the short dates.

In such situations it can be useful to compare the bonds on prices rather than yields.  It also makes sense to consider cash neutral hedges rather than duration weighted hedges.

More evidence that I am not alone in expecting a restructuring.  I should add though that the plunge in the Euro this week on news that Germany might not be carry out its part in the bailout points to continued belief that creditors will be protected at the expense of the currency.

Jun 4, 2010

Risk aversion ebbing as non-farm payroll approaches

Participants look set to continue adding back the risk jettisoned over the last few weeks.

It will be interesting to see how bonds respond today with non-farm payroll numbers typically bringing the volume that allows for big moves.  I would expect with momentum weakening in the recent rally and some talking of up to 700k jobs added in May that bonds end the day lower.

In commodities, it looks like oil is set to regain some of the ground it lost to gold recently.

May 31, 2010

Memorial Day Links: No Bubble in Australian Housing and Greek Problems Continue

"The short story is that the escalation in housing costs has been mainly motivated by underlying demand- and supply-side fundamentals, not leverage as some doomsayers would have us believe. "

“Could this be the last weekend of the single currency? Quite possibly, yes.” (Hat tip Calculated Risk)

May 30, 2010

Long-term perspective on currencies and central bank policies

I was doing some house cleaning, tagging old entries and came across something I wrote in 2005 on central bank policies:
On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.
This referred to the US dollar but the underlying logic still applies to this week's scare regarding China turning seller of Euro assets.  China has deep pockets and very little interest in adding to currency instability.  The status quo (Yuan pegged at sub-market rates to stimulate Chinese exports) has done well by them and while it can't go on forever now would be a shockingly poor time for a drastic change.  Why would they do this in the midst of speculative fervor to short the Euro and a general panic regarding European assets?

My 2005 self went on to make the following predictions:

There will be some sort of market event with the most likely candidates being housing and interest rates.
This market event will ultimately require international cooperation (G7, G10). It may take a series of trials (maybe a series of crises) by various CBs and governments but eventually they will need to coordinate policy. The world will need to decide how to handle the issue of the weakening dollar as its main reserve currency.
On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.
Unemployment seems like the best indicator of how hard or soft the landing is in the real economy. Below the June '03 high of 6.3% seems like a good definition of a soft landing for the U.S.[The main question being discussed was whether the US was whether the Fed hiking cycle was leading up to a soft landing.]
The U.S. current account deficit will get worked off through the growth of emerging market consumption rather than U.S. economic contraction. These emerging economies are the logical target for the world's investment dollars so once the market regains control of capital distribution they should see some benefits.
While this was a useful high level map, in the end it mostly helped me to avoid risks.  The policy coordination I expected has yet to materialise and instead it is a dog eat dog world of competitive currency devaluations.  This makes a fertile (read volatility swings) ground for trading, especially in currencies.  I expect this will continue until central bank coordination occurs enabling debt-heavy importing countries to start paying off their creditors.
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May 27, 2010

Technical Analysis 101: Adam and Eve

I got bullish a bit early on equities last week as the Euro bounced and it felt like panic was in the air on the day of the German trading bans.  Still the pattern in stocks looks constructive for the short-term with a target above S&P 1150 (SPY 115).

The chart for SPY bears a striking resemblance to a double bottom pattern with momentum ebbing as the panic low from two weeks back gets retested.   Also, as Bill Luby points out options traders seem to be getting ahead of themselves pricing implied volatility trading above what is being observed.

I am only playing through upstrike call options (where implied vol is less dear), so my downside is limited.  Momentum players may still have stocks to dump so I have positioned for a bounce but kept the risk low.

If we do manage a rally here it is easy to imagine the news coverage shifting to discussing the liquidity enema eminating from central banks as equity positive.

May 19, 2010

Are German naked short and CDS bans really that awful?

In response to the German bans on some naked short-selling and naked credit default swap (CDS) purchases Zero hedge declares:
If this pans out as expected, look for Bunds to collapse tomorrow, and wipe out a few billion from Pimco's NAV. We warned in February that the flight to safety in Bunds was both shortsighted, and too good to last.
I disagree.  Banning naked short selling and unmatched CDS purchases are fairly mundane regulatory changes.  Shorting is still allowed as long as the bonds or shares can be borrowed and default swaps are still available but only for hedging purposes.  Coming so soon after the bailout announcement, this is being linked to the "wolf pack" behavior mentioned by officials last week but these policies are in line with reform recommendations from before the Greek crisis made it to the front burner.

This may be the sort of news that can set off a panic given the view by many that the Europeans are flailing about but I expect the real money will take note of the limited scope and difficult enforcement of today's bans.  While I agree that Europe has not yet come to terms with Greece as a solvency problem rather than a liquidity problem, the current approach is still printing Euros to pay bond holders, so the downward pressure should stay focused firmly on the Euro.

With the lopsided view and large short positions in the Euro currently, I am not even sure the one way trip down there can continue through tomorrow.

May 8, 2010

Stock market stunned by its own fragility

The price action this week in equities was a change of pace.

Volatility Chart

I included the chart above to show just how low the short term volatility of SPY had fallen before the recent pull back.  As much as much as the Greek debacle may be the proximate cause of the stock drop, the steady grind higher over the last two months had left the market ripe for a pull back. The price drop is severe enough that momentum traders will be throwing out positions while value investors will still be on the sidelines for a few hundred more S&P points.  

US stocks continued lower on Friday, but the long bond and the Euro changed direction.  The long bond has been on a strong two week run up that was goosed higher by yesterday's late afternoon panic, while the Euro had been weakening in response to Europe's sovereign debt woes. Both trends are stretched but seem well supported by the current fundamentals.  The reversals in these markets, though mild, makes me think equities will not start next week in free fall.

The Greek saga (which began in early December 2009) dominated the headlines with European policy as of last weekend looking to keep the monetary union intact at the cost of a steadily weakening Euro.   There is still a lot of skepticism whether the current bailout for Greece is enough and whether the same thing can be done for the other PIIGS but it seems to me that where there's a will there's a way.   This is the train of thought that is driving the weakening Euro.  It may still happen that Greece abandons the Euro (likely leading to a sharp recovery in the currency) but I think the policy response of last weekend postpones it by a year while the powers that be wait to see if the austerity package works its magic.

A Greek debt restructuring will also relieve some pressure on the Euro and provide a far better template for the other PIIGS (should their situations worsen) to follow.  For all the weekly on again off again bailout announcements regarding Greece it is still not clear the authorities have done their homework and come up with a plan for the Euro and European debt markets that won't need to be reevaluated in the near future.  This lack of credible long term goals is the key uncertainty spooking the markets.  This thought from 2004 still reflects my view on why attempts to use the bailout package to discipline the Greek government is misguided.  

Most of the economic news out of the US has been positive, though ignored.  It was capped off today by  the best jobs report in years.  The positive recent news is being ignored due to fears of slowing growth in the second half of the year. As the US fiscal package winds down there is no obvious candidate to replace it.

Apr 22, 2010

Financial reform moves closer to passing

From the WSJ:
Democrats won the support of a senior Republican who voted in a Senate committee Wednesday for a sweeping overhaul of the market for derivatives, the complex financial instruments at the heart of the financial crisis.
With 41 Republican's in the Senate this is a critical achievement for the bill.  It will be interesting to see how bank shares react.  Tim Duy highlights positive developments making the economic recovery looks sustainable but stock prices and risk assets still appear to be on the high side.

This is particularly true of bank stocks given the public outrage over the pay structure and conflicts of interest.  Reducing systemic leverage is another likely regulatory theme.  Regulatory uncertainty along with lingering insolvency fears make it difficult to understand how owning bank shares makes sense to anyone here.  My personal view is that bank shares are in for a lost decade as deleveraging and capacity reduction work through the sector.  We shall see.

Apr 19, 2010

Link summary from my other blog

I had begun a new blog a few weeks ago while Globaltrader.blogspot.com was still unavailable for posting.  I plan to continue posting only on this blog now that it is restored but if it is removed by Google again I will return to that one.

Posts over the last few weeks had been:

Apr 10, 2010

Are there scale economies in banking?

Mark Thoma concludes his summary on whether scale economies in banking justify the existence and benefit of large banks with the following:

I'd like to know the source of the scale economies. The paper linked above estimates returns to scale, but not their source. As noted in the introduction (and also noted by David):
Our results indicate that as recently as 2006 banks faced increasing returns to scale, suggesting that scale economies are a plausible (though not necessarily only) reason for the growth in bank size...
Without knowing the source of the changes in costs as banks increase in size, the (non-parametric) results -- results that differ from most previous work -- are hard to evaluate. I've been hoping for good estimates of the size and nature of the economies of scale for banks, but I'm not fully convinced by this evidence.

Mark is correct to try to figure out the specifics that are driving the returns in the study.  From my own experience - sales and trading in loans, bonds, and commodities - scale is found mostly through network effects.  The market players that have the most trading flow and transactional experience in a particular market have the accurate prices and up to date information.  This advantage leads to a higher return by being more likely to earn the bid / offer spread when making markets and being able to price services at a premium with clients wanting information access as well.  While this can be a stable and profitable advantage it was a small part of the profit in the banking areas I have worked in.

I would expect other economies of scale on the deposit taking side of the business as servicing a large number of depositors in a centralised fashion seems like a classic scale business.  The number of clients and transactions adds little marginal cost while the licensing, reputation, and infrastructure represent substantial fixed costs.  This advantage is hived off from the risk taking and higher margin bank  businesses with the internal treasury and risk department charging LIBOR plus a spread for use of funds.  These risky parts of the business still tend to grow fairly large despite the absence of scale economies.  I attribute this to the money politics of the industry as empires grow and shrink based on raw profit.  Growth is revenue rather than cost driven.   This fits well with the ease that hedge funds have found competing against banks in sales and trading functions though funds usually start with few people and no scale.

Another thought that I had from reading David's post, was that even if there are economies of scale that does not justify "too big to fail".  It shows that big can be a public benefit but if that is the case then a system needs to be created so that the naturally big entities created can be wound down effectively if necessary.  I believe this is now widely accepted following the difficult ad hoc responses that became necessary for troubled large institutions in 2008.

Particular banking businesses may need to be large to get the maximum public benefit but for the reasons above I doubt this applies to the financial industry as a whole.  Careful thought should be given so that if a safety net for large institution needs to be maintained it only applies to functions that can justify scale benefits.  If scale can be justified it still does not justify the lack of a mechanism to wind down large institutions when necessary.