Trading Tips

Using Secondary Indications in Your Market Analysis

Yesterday Adam at Forex Blog put up a blog post looking at the British Pound, specifically in terms of GBP/USD. He throws a lot of different stuff into his assessment of the UK currency, part of which is looking at the prospects for a rate hike by the Bank of England. To that end, let me share two charts I keep an eye on in my work.

This first chart shows the spread of UK 2 year Gilt rates over the US 2yr Treasury Note rate, with the spread’s correlation to GBP/USD in red as the lower plot.

The second chart is the same as the one above, but swapping German Bunds in place of US Treasuries and running the correlation against EUR/GBP instead of GBP/USD.

I offer up these charts for a couple of reasons. One is to show the sort of secondary analysis professionals use to assess the markets. Another is to show how frequently market correlations can change. We would expect a positive linkage between the UK/US rate spread and GBP/USD and a negative one between the UK/German spread and EUR/GBP, but that’s not always the case.

The third reason for showing these charts is to show what’s been going on in these spreads lately. The UK/German spread has fallen sharply, strongly indicating the market’s view on whether it will be the ECB or BoE the moves first to hike rates has moved strongly in favor of the former. Things are less dramatic in the UK/US spread, but the breakdown there hints that fixed income traders have become less confident about a BoE rate move in the short-term in general, not just as opposed to the timing of the ECBs action. These are the sorts of things the professionals are looking at and thinking about in making their market judgements. It’s all related.

Trading News

It’s not QE 2, QE 1.5, QE Lite or anything like that!

In case this post’s title didn’t tip it off already, I’ll state my position as clearly as possible.

What the FOMC said today about using the principal payment from the MBS and agency holdings to purchase longer-dated Treasuries is NOT NEW QUANTITATIVE EASING.

With all due respect – realizing that in some cases none is due – anyone who suggests otherwise is being a moron. (I do like Mish calling it “quantitative nothingness”, though)

The Fed is not expanding their balance sheet at all with this move. They are simply shifting assets from one category into another. Yes, the implications for the rates market are significant. That is a structural thing, however. If you shift from one asset to another, it is naturally going to cause an impact in pricing when you’re dealing with Fed-level size.

As Dennis Gartman noted on CNBC’s Fast Money program this afternoon (which I caught while seated in the barber’s chair), it means nothing anywhere else. Actually, let me correct myself. It does indicate the Fed’s unease about the current economic environment, but the markets already knew that. That’s why stocks, Treasury rates, and the dollar have all been working mainly lower the last few weesk.

Gartman was specifically addressing gold with his comments, however, and by extension the dollar. Those two markets tend to move in opposite directions in the face of monetary expansion because of currency devaluation/inflation concerns. Today’s action by the FOMC has no impact there because it didn’t change anything – and that’s the whole point. The Fed is keeping it’s balance sheet stable – no expansion or contraction of money supply. Had the Fed not decided to roll the principal repayments over it would have done the latter.

So we’re still in QE 1.0 as far as I’m concerned. When all the MBS/Agency/Treasury buying was going on there were all kinds of questions about the unwind. Letting the securities mature is a natural unwind. What the Fed did today was to tell us that they are not prepared to start that unwind process just yet. No new balance sheet expansion is going to take place, so we can’t say another round of QE is going to happen.

Does this open the door to a QE 2? I’d say that door was never really closed after the  QE1 purchases ended. It could still happen, though the odds are not good.

Here’s something to keep in mind. The Fed didn’t say anything about reinvesting the coupon payments from the securities they hold. Had they done that, and thus expanded the balance sheet in the process, I’d have called it a new round of QE. As it stands, every time the Fed receives one of those coupon payments it’s decreasing the money supply a bit. It’s not as big an amount as the principal would be, of course, but it is still a slow drain.

So why did the market’s react as they did Tuesday? Treasuries went up because the Fed will be buying them again. I didn’t see the figures, but my guess is that mortgage spreads may have expanded a bit as a result. Stocks rebounded some, but never really got close to going positive. The dollar took a hit, but was already working lower after some overblown gains earlier in the day. None of the moves really persisted much beyond the initial reaction, which tends to support my view that this isn’t a big deal. The implications of the Fed calling the economic recovery weaker than expected and not likely to improve any time soon are more important going forward.

P.S.: As you may have gathered, I actually wrote this Tuesday evening, but didn’t publish it right away to let my thoughts settle out overnight. Listening to things this morning, it sounds like a few more folks are of a view similar to mine (including BoE boss Mervyn King) given how they are avoiding the use of any variation in “quantitative easing” in their commentary.

Trading Tips

Taxes, Budget Deficits and Inflation

A couple of things have come out from different politicians the last couple days which have me shaking my head. File this under big picture macro fundamental anlysis, I suppose. I don’t normally offer up market analysis here, but it’s worth indicating the way one can approach market analysis.

Tax Hikes Leading to Inflation
The first is a statement yesterday by the governor of the Mexican central bank. In talking about forecasts for the year to come he expressed the view that tax hikes instituted in the latest budget could add 50bps (0.50%) to the annual inflation rate in 2010. I can only pressume that he means said tax cuts will somehow filter through into higher consumer prices as a pass on effect.

Now I don’t know the specifics of the tax hikes in question, so I can’t speak directly to the type of pass-along effect there might be and from what directions. I seriously doubt it would ever be a 100% pass through from producers to consumers, and some of the hikes may directly hit comsumers, which wouldn’t be involved in price levels at all. In other words, I have lots of questions about how much pass-along there is likely to be.

On top of that, there are two other elements to the inflation equation. To the extend that pass-along taxes increase prices and/or taxes directly impact consumer it will lower demand. That would tend to put downside pressure on prices. Furthermore, when the government increases taxes it pulls more money out of the system, reducing money supply. If inflation is at least partly a function of money supply, then taxes tend to be a depressive factor rather than an expansionary one.

Government Budget Deficitis of 3%
US Treasury Secretary Geithner was on CNBC this morning talking about the plan to get the US budget deficit down to 3% of GDP with the work on getting it down there starting in 2011. The EU finance ministers set similar targets for several members to reach by 2012-2015. So in other words, the world’s major economies will still be running budget deficits for quite a few more years to come.

Why is this important? Because one of two things have to happen. Either more sovereign debt (Treasuries, Gilts, Bunds, JGBs, etc) have to be issued or the monetary base will expand by the amount of those unborrowed deficits. In the latter case you get inflationary pressures. In the former you get lots more supply of debt instruments. Both tend to equate to higher interest rates over time.

Now if all countries are running deficits and not issuing debt to offset then everyone will see inflationary pressure, but it will tend to be cancelled out in the forex exchange rates. Things like commodities (think gold and oil), however, would tend to see price appreciation.

The Basics

Looking at Volatility Across Markets

The other day I commented on a post on a personal finance blog. The article was an introduction to forex. I won’t link to it here because it was very poorly done, falling short on many points. One of the things that tripped off alarm bells early on about where the post was going was this statement:

However, it is important to note that forex trading is rather risky, and the currency market is quite volatile.

All trading is rather risky, so I won’t address that particular point. I will, however, speak to the issue of the currency market being quite volatile. Statements about the forex market being more volatile than others are made all the time – almost always by folks who are putting forex trading down in some fashion or another. As I’m going to show you, the numbers make it pretty clear that forex is in fact on the low end of the volatility scale when looking at all markets.

Here is a look at the last year worth of volatility in forex rates

Pair Daily StdDev Avg Daily Rng
EUR/USD 0.93% 1.41%
USD/JPY 0.91% 1.45%
GBP/USD 1.00% 1.65%
USD/CAD 1.02% 1.60%

The first column is the standard deviation (a commonly used volatility metric) of the daily % change for the one-year period beginning November 1, 2008. The second column is the average daily range, with each day’s range being expressed as a % of the prior day’s close ( [H-L]/C ). I went with % changes and ranges to make things directly comparable across markets. So from this data we can see that USD/CAD tends to see the biggest daily changes, though GBP/USD tends to have slightly wider daily ranges.

Now let’s compare that to the major US stock indices.

Index Daily StdDev Avg Daily Rng
Dow 2.01% 2.41%
S&P 500 2.26% 2.60%
NASDAQ 100 2.18% 2.69%
Russell 2000 2.89% 3.28%

Here we can see about what as we would expect in terms of the small cap Russell index being the most volatile in terms of both price changes and ranges.

And how about individual stocks?

Stock Daily StdDev Avg Daily Rng
IBM 2.18% 2.85%
GE 4.20% 5.59%
AAPL 2.66% 3.44%
GOOG 2.51% 3.33%
AMGN 2.33% 3.03%
XOM 5.95% 6.66%
JPM 2.23% 2.88%
KO 1.74% 2.45%

All of the above are clearly large-cap stocks which would generally be expected to show less volatility than mid- or small-cap stocks (as witnessed by the higher volatility in the Russell index). Even still, with the exception of KO, they are all much more volatile than the forex pairs.

So what about commodities?

Commodity Daily StdDev Avg Daily Rng
Gold 1.61% 2.38%
Oil 4.35% 6.01%
Nat Gas 4.91% 6.54%
Corn 2.70% 3.83%

Again, the commodities are clearly much more volatile on a day-to-day basis than are forex rates.

Now to add in a market that’s considered the least risky by many folks – interest rates.

Instrument Daily StdDev Avg Daily Rng
Eurodollar 0.05% 0.06%
2yr Treasury Note 0.13% 0.18%
10yr Treasury Note 0.63% 0.92%
30yr Treasury Bond 0.99% 1.50%

I’m using the futures for the prices above. Finally we have a market where volatility is lower than forex! As you can see, the shorter maturity instruments (Eurodollars are 3mo) are calm compared to the others we’ve looked at here. Bonds, though, are in line with the volatility readings we see for the forex pairs.

So the bottom line is that not only are forex prices NOT the most volatile, they are actually on the lower end of the spectrum when looking at available markets. The numbers demonstrate it pretty clearly, even in a 12-month period which has seen its fair share of volatile trading.

Now granted, the application of leverage in forex creates the opportunity for very high levels of volatility in one’s trading account – but that’s not the market’s fault. Traders don’t need to use leverage. You can trade forex without it.

The Basics

What is Commercial Paper?

Commercial Paper (CP) is something which has been in the news for the last month as the center of the credit crunch. If you don’t know what CP is, here’s a definition:

Commercial Paper is an unsecured debt obligation issued by corporations and banks to for short-term financing purposes, often to fund such things as accounts receivable and inventory costs. Maturities generally are from 2 to 270 days in length and the denominations cover a wide spectrum with a numerous different type of terms. The secondary market is limited where it exists at all. Most issuers are companies with high credit ratings, meaning that the investment is almost always considered relatively low risk.

That last sentence is particularly telling. It’s certainly not the way things are playing out right now. Folks who would normally purchase CP have become reluctant to do so. They are concerned that those issuing the debt won’t pay them back. As a result, the whole market has come to a screetching halt, putting a number of companies in a major bind. This action was part of the events which motivated the Fed to lower the Discount Rate, and why so many folks have been calling for a cut in the Fed Funds rate.

It is worth noting that the problems with CP issuance have primarily been among financial companies, and not really focused on non-financials. The latter have seen CP rates (what they have to pay in interest) rise a bit, but nothing near what the financials have had to deal with.

The Basics

LIBOR? What’s that?

If you’ve been paying much attention to the markets of late you probably heard something about LIBOR in relation to the ongoing credit issues that are impacting not only the US, but also Europe and elsewhere. So what exactly is this mysterious thing?

Here’s a definition from the British Bankers Association:

“Libor stands for the London Interbank Offered Rate and is the rate of interest at which banks borrow funds from each other, in marketable size, in the London interbank market.”

For the purposes of our discussion, LIBOR is the overseas rate for US Dollars. It’s basically equivalent to the Fed Funds market between banks domestically. The difference is that it deals in terms of Dollars on deposit outside the U.S. – eurodollars. Which brings us to another market.

Eurodollar futures are based on the 3mo LIBOR rate. For example, the September Eurodollar futures will be valued at 100 (par) minus the 3 month LIBOR rate when it expires (Sep. 17th, right before the Fed meeting). So for example if LIBOR (specifically the BBA’s fixing that day) is at 5% that day, the Eurodollars will be priced at 95.

The issue that has made big news of late is that LIBOR has been running very high, much higher than the Eurodollar futures. For example, on Sept. 5th the LIBOR rate was 5.72% and Sep. Eurodollars were at 94.44 (down from a high of about 95.00 on August 21st). The LIBOR rate implies 94.28 Eurodollars. Those two must converge by the 17th. The question folks in the market have been asking is which one of those markets is correct.

Just like in Fed Funds a short while back and Commercial Paper, the LIBOR rate has been under upward pressure because of counterparty credit concerns. To put it simply, the banks and such that operate in the LIBOR market don’t have a lot of trust thanks to issues related to sub-prime, so are pricing a risk premium into the rate at which they are willing to lend overnight funds.

A related subject is the so-called TED spread. That’s the T-Bill/Eurodollar spread. Once upon a time it was a fairly common discussion point and even an oft traded futures spread. For many years, though, the spread was tight and not very volatile. The flight to quality into T-Bills recently, however, has caused that spread to become much more interesting. As a result, you’re hearing about it in the news once more.

The Basics

The Discount Rate and What it’s all About

Some of you out there might not realize that the Federal Reserve actually sets two different rates. The one that gets the most press and is generally referred to is the Federal Funds (Fed Funds) target rate. When you hear about the Fed raising or lowering interest rates, it almost always means a change in the Fed Funds rate.

The Fed Funds rate is an overnight interest rate between banks when they borrow and/or lend reserves to each other. Reserves are what banks are required to keep on deposit with the Federal Reserve based on a fraction of the deposits they have from customer accounts. Those requirements change with in and outflows to the banks, so at points some banks will have excess reserves and others shortfalls. Those with the excess reserves lend to those who need to make up the difference between what they have and what they are required to have. The Fed Funds rate is the interest rate the lenders of reserves charge the borrows of them.

As I noted in Liquidity, Fed Action, and all that Stuff, the Fed Funds rate moves based on supply and demand and the Fed acts to try to keep the rate in line with its target.

The Discount Rate is something the Fed tends to move less frequently. That is the one which got lowered this morning.

The Fed’s Discount Window is a back-up to the Fed Funds market and essentially is how the Fed becomes the lender of last resort. Banks in need of reserves can go to the window to borrow those reserves directly from the Fed if they cannot get them in the Fed Funds market (click here for more details). Thus, through the Discount Window the Fed can provide the market with needed liquidity, which is what has been the big problem of late.

Until today, the Discount Rate was 100 basis points (one full percentage point) higher than the Fed’s target Fed Funds rate. Basically that means banks forced to used the Discount Window were faced with a 100 basis point penalty (give or take) for not being able to get the reserves they need through the Fed Funds market. By cutting the Discount Rate today, the Fed essentially cut that penalty in half.

Now the Fed doesn’t just shell out cash at the Discount Window. They require collateral for the loans. Today, in addition to the cut in the Discount Rate the Fed also widened the the array of securities permissible for use as collateral. On top of that, they also lengthened the maximum possible loan time. All of that together will help provide more liquidity to a market that was desperately in need of it.