Excellent post Abob, I was wondering why the big move in the Asian session 
Money grows on the tree of persistence
When I trade currencies from a global macro perspective I find it useful to draw on the signals sent out by the other financial markets. Recent moves seem to have some observers scratching their heads a little:
The latest Buttonwood column of the Economist for example, is titled 'Mixed messages' and points out the following divergences across markets:
'WHEN asset classes diverge, investors should take note. Bond yields have fallen sharply in recent weeks, with the ten-year treasury bond yielding 4.53% on September 25th, compared with 5.24% in June. That, and the recent weakness in commodity prices, might seem to indicate an imminent economic downturn.
But investors in shares do not seem overly concerned. The Dow Jones Industrial Average has been flirting with its record high of 11,722, set back in January 2000. The Belgian and Spanish stockmarkets have recently scaled new peaks. And emerging-market bond spreads, a good indicator of investors' attitude to risk, are around their lowest levels of the past 14 years.
I think the author is creating unnecessary confusion by mixing yields with prices. Look at everything from a price approach: Stocks have gone up, and bond prices have gone up. Risky bonds have gone up in price relative to government bonds (which have also gone up). The only asset which has fallen in price here is commodities. Falling commodity prices could in part be due to concerns on growth, or they could be a correction of recent excess, or they could be due to reduced inflationary expectations.
In my view, there is no great divergence. What is clear is that the market is now significantly less concerned over inflation than it was in the first half of the year. This is an absolute positive for equities.
While there are question marks over economic growth we need to keep in mind where the we are coming from: it wasn't so long ago that market players started talking about stagflation (high inflation and low growth). High inflation and low growth is a double negative for for equities. The bond market also treated the scenario as a net negative, perceiving the inflation risk as more than offsetting the downside risk to growth (all things being equal bonds would normally rally on poor growth news). While concerns over growth clearly remain (and may be growing), inflation is the stronger poison to bonds and equities a like, and so as this risk has become more dilute, equities and bonds have both rallied. With reduced probability of excessive continued tightening by the Fed, the market has renewed its appetite for risk, and this could be in part what is being reflected in a lower emerging market bond spreads.
Buttonwood goes on to say:
It is hard to see how both the bond and equity markets can be right. Equity investors seem to assume that the global economy will display the same resilience as it has in recent years; taking that view has been a bet that has paid off since 2003. But the bond markets almost have an each-way bet on a slowdown: “Ashes to ashes, dust to dust, if the Fed doesn't get you, then housing must.”
The forecasting record of bond markets is not perfect: remember the deflation scare of 2003? But given the scale of the decline in yields, and the fickleness of stockmarkets, it would be foolish to bet against the bond market's judgment.
As I said above, I don't think its a case of one or the other. More importantly, is the stock market any more 'fickle' than the bond market? Where is the evidence. All in all then, I think this is a disappointing piece from a normally excellent Buttonwood.
A similar theme is picked up on it the Capital Spectator blog, an excellent economics blog:
'The stock market has been shrugging off recent signs of weakness in the economy and the bond market has been embracing the trend. One market is wrong; one is right.'
http://www.capitalspectator.com/archives/092706.GIF
The above chart is provided to highlight how bonds and equities have tended to move in opposite directions, and owning both can provide good diversification benefits because 'each asset class is driven by different trends'. I think this statement is questionable. Not only is inflation a major driver of equities and bonds (in the same direction), but moves in the bond market directly influence the equity market (yields are important in determining the present value of equities). On the topic of diversification, it can pay to look at the bigger picture. The chart below is from an old Morgan Stanley publication and highlights that on average the correlation is actually positive. This is what you would expect: lower yields (from higher bond prices) are good for stocks. So in some respects bonds and equities are actually a substitute for one another.
Why the negative correlation in recent years then? Well, remember that equities first crashed through 2001 and the Fed (in large part in response to this) sent rates tumbling down to 1% by mid-2003. Equities, supported by low interest rates, have smartly recovered as the market has moved away from a 'deflation' scenario (in 2003, yields in the bond market plumbed fresh lows) toward a more balanced picture. I believe, the equity crash and policy response is is the exception rather than the rule (either way, we are through that phase now) and that a positive correlation between bonds and equities makes perfect sense going forward.
All this, and no talk of currencies!
It's all related
The latest Buttonwood column of the Economist for example, is titled 'Mixed messages' and points out the following divergences across markets:
'WHEN asset classes diverge, investors should take note. Bond yields have fallen sharply in recent weeks, with the ten-year treasury bond yielding 4.53% on September 25th, compared with 5.24% in June. That, and the recent weakness in commodity prices, might seem to indicate an imminent economic downturn.
But investors in shares do not seem overly concerned. The Dow Jones Industrial Average has been flirting with its record high of 11,722, set back in January 2000. The Belgian and Spanish stockmarkets have recently scaled new peaks. And emerging-market bond spreads, a good indicator of investors' attitude to risk, are around their lowest levels of the past 14 years.
I think the author is creating unnecessary confusion by mixing yields with prices. Look at everything from a price approach: Stocks have gone up, and bond prices have gone up. Risky bonds have gone up in price relative to government bonds (which have also gone up). The only asset which has fallen in price here is commodities. Falling commodity prices could in part be due to concerns on growth, or they could be a correction of recent excess, or they could be due to reduced inflationary expectations.
In my view, there is no great divergence. What is clear is that the market is now significantly less concerned over inflation than it was in the first half of the year. This is an absolute positive for equities.
While there are question marks over economic growth we need to keep in mind where the we are coming from: it wasn't so long ago that market players started talking about stagflation (high inflation and low growth). High inflation and low growth is a double negative for for equities. The bond market also treated the scenario as a net negative, perceiving the inflation risk as more than offsetting the downside risk to growth (all things being equal bonds would normally rally on poor growth news). While concerns over growth clearly remain (and may be growing), inflation is the stronger poison to bonds and equities a like, and so as this risk has become more dilute, equities and bonds have both rallied. With reduced probability of excessive continued tightening by the Fed, the market has renewed its appetite for risk, and this could be in part what is being reflected in a lower emerging market bond spreads.
Buttonwood goes on to say:
It is hard to see how both the bond and equity markets can be right. Equity investors seem to assume that the global economy will display the same resilience as it has in recent years; taking that view has been a bet that has paid off since 2003. But the bond markets almost have an each-way bet on a slowdown: “Ashes to ashes, dust to dust, if the Fed doesn't get you, then housing must.”
The forecasting record of bond markets is not perfect: remember the deflation scare of 2003? But given the scale of the decline in yields, and the fickleness of stockmarkets, it would be foolish to bet against the bond market's judgment.
As I said above, I don't think its a case of one or the other. More importantly, is the stock market any more 'fickle' than the bond market? Where is the evidence. All in all then, I think this is a disappointing piece from a normally excellent Buttonwood.
A similar theme is picked up on it the Capital Spectator blog, an excellent economics blog:
'The stock market has been shrugging off recent signs of weakness in the economy and the bond market has been embracing the trend. One market is wrong; one is right.'
http://www.capitalspectator.com/archives/092706.GIF
The above chart is provided to highlight how bonds and equities have tended to move in opposite directions, and owning both can provide good diversification benefits because 'each asset class is driven by different trends'. I think this statement is questionable. Not only is inflation a major driver of equities and bonds (in the same direction), but moves in the bond market directly influence the equity market (yields are important in determining the present value of equities). On the topic of diversification, it can pay to look at the bigger picture. The chart below is from an old Morgan Stanley publication and highlights that on average the correlation is actually positive. This is what you would expect: lower yields (from higher bond prices) are good for stocks. So in some respects bonds and equities are actually a substitute for one another.
Why the negative correlation in recent years then? Well, remember that equities first crashed through 2001 and the Fed (in large part in response to this) sent rates tumbling down to 1% by mid-2003. Equities, supported by low interest rates, have smartly recovered as the market has moved away from a 'deflation' scenario (in 2003, yields in the bond market plumbed fresh lows) toward a more balanced picture. I believe, the equity crash and policy response is is the exception rather than the rule (either way, we are through that phase now) and that a positive correlation between bonds and equities makes perfect sense going forward.
All this, and no talk of currencies!
It's all related
"Always bet on black"
http://www.currenex.com/images/eForeX-logo.gif
The latest edition of E-Forex magazine has a couple of interesting articles. The first (pages 35 to 38) looks at the issue of one-click trading, global liquidity and slippage. It's not really relevant to global macro/position trading, but its pretty cool. Here are some of the interesting points:
- Ideal case spreads: Simulating the 'best of the best', the authors put together the best prices from four FX marketplaces (Dukascopy, Lava, Hotspot, and Currenex) and a selection of leading bank liquidity providers, to give the prices of an ideal marketplace.
The experiment ran on 18/10/06 from 14:10 GMT to 15:10 GMT, and the results are pretty cool: The EUR/USD spread is just 0.903 pips, GBP/USD is just 1.52, USD/JPY 1.05 and USD/CAD 2.20. In terms of spread distribution, EUR/USD was at 0.5 pips for 21% of the time, 1.0 pip for 65%, 1.5 pips for 10%, and 2 pips for just 4% of the time. The average bid life span for EUR/USD was 3.01 seconds (ie before it the price changed).
I guess this experiment didn't take place over a key data release, because the upward spike in the spread would have skewed the results. I think it would have been interesting if it was carried out for a full trading session.
- Trader delays: Given the speed with with FX market prices update, the ability of the human trader to react to these changes needs to be considered. There are two delays in the trader's response: First, there is the internet connection delay between you and your broker, and then there is the actual ability of the trader to recognise and respond to the data.
The physical location of the trader relative to the broker is less important than the trader's response time, but it still plays a role in adding to the response lag. In a table of ping response times between the Duksascopy server in Switzerland and in other countries, the delays were: UK (0.030 seconds), USA (0.095), Canada (0.120), Brazil (0.280), Japan (0.310), China (0.450).
Dukascopy also have a great tool that tests traders reaction times. The article says the average reaction time of a human trader, in 'one-click' activity, is 0.4 seconds. Have a go. My average time on the second go was 0.37 seconds, with a single fastest response time of 0.26 seconds.
They offer the following exercise:
- Test your own reaction delay.
- Measure your ping connection to your broker
- Add them together to give your total delay time.
Why is this important? Well, with FX prices changing so fast, and given these additional lags, we are faced with the possibility of slippage - ie that is clicking on a price that is no longer valid and getting filled at a different price. The article says that with a total delay of 0.4 seconds, the trader has an 8% chance of slippage, but this is reduced to 4% if the trader uses a local broker and has a delay of just 0.35 seconds (not much difference, eh!).
They recommend using a broker with slippage control on one-click trading, or using the 'place bid/offer' function in marketplaces, to ensure you get your always price.
The authors conclude with the view that spreads will continue to tighten, with faster and faster price updates, that more tools will be made available to avoid slippage, and that the FX industry will compete to be as geographically close to the trader as possible.
In the meanwhile, if you are a rapid-fire trader and have a system where every millisecond counts, I recommend serious traders practice your cat-like reflexes daily (a good excuse to keep your playstation or X-Box!) and move home to be as close to your broker as possible.
"Always bet on black"