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Game Theory Trading
Given the recent upsurge in government intervention in the economy (and financial markets), as well as the collusion between banks and government in response to the financial crisis (AIG CDS undwinds, NY Fed's Goldman shares ahead of BHC announcement, etc. etc.), following "smart money" has now come to mean following those in-the-know of future government actions, or at least those with high predictability or involvement.
Back in June 2008, the Treasury's Exchange Stabilization Fund's Euro reserves dropped dramatically, to the tune of about €6 billion, as reported by the Treasury's weekly releases on international reserve positions. This large supply of Euros presumably was used to finance demand for dollar derivatives, allowing the Treasury to pull a large of USD out of the market. Indeed, the ESF's actions correlate very well with the collapse of the commodity bubble and the beginning of the Dollar bull, as is evident in the image below, courtesy of Now and Futures:
The ESF's actions, by pulling liquidity, also could have been the "push" catalyst for a number of credit events in the following months, which further increased demand for USD as entities rushed to deleverage and pay off dollar-denominated debt. The Fed's extension of dollar liquidity swaps drawn on by foreign entities also helped the Dollar.
Since, the Fed's liquidity swaps have been on the decline, pushing the Dollar back down, and allowing currency depreciation to have the reciprocal effect on equities.
Mean reversion, of course, is an inevitable law of nature. The exogenous catalysts that set off the positive-feedback systems that unwind years of imbalances vary, however, and the recent government actions have become the new norm for this.
The Treasury and Fed are now at a crossroads. The Dollar Index is back to 2007-2008 levels, as the liquidity-driven rally in equities has been met with pervasive USD selling. Crude oil is back to $70/bbl and further depreciation of the Dollar could push oil back to triple digits, especially if the Dollar Index breaks its important support around 72. $80/bbl+ oil cannot be at the forefront of any sustainable economic recovery.
On top of that, Treasuries have tanked since January's highs and sold off massively since QE was initiated back in March. 30-yr Tsy rates have more than doubled off their lows in less than nine months, and the 6% mortgage is back. 6-7%+ mortgage rates are much too expensive to allow any economic recovery, and Bernanke's quest for 4.5% mortgage rates at the beginning of QE clearly cannot be reached if current trends sustain.
The fact is, the Fed and Treasury both need a large, swift suppression of rates to reflate credit to catalyze nominal recovery and to be able to roll over the enormous national debt and keep spending.
Just like last summer, when the Dollar was depreciating so quickly and crude had reached levels of "energy crisis," we are now at an important crossroads for the USD. Back then, interest rate hikes to defend the USD were being considered. Now, clearly, that is not an option whatsoever. In fact, rates are much too high as it is and the Fed Funds rate has reached its nominal price floor of zero.
The only option for the Fed/Treasury is to somehow spur organic demand for USD and Tsys. Nothing like a crash in equities and commodities to do that.
And if the Fed and Treasury are incentivized for a risk asset crash to provide inflows into the USD/Tsy "safe haven" trade, why bet against it?
As always, the question is where does this market top? There is ample evidence that this rally is a "works-until-it-doesn't," positive feedback, liquidity-driven, unsustainable market event; however, timing the top and positioning yourself for the selloff is not an easy task.
Technical chart analysis to find important resistance levels where sufficient supply in volume may be offered to stop the rally in its tracks is my preferred method of timing market moves. However, in the context of the Fed's/Treasury's actions, a look at the Fed's POMO schedule may provide some hints as to when the liquidity driving this rally dries up.
Since QE wasn't extended, the last POMO date scheduled as of now is in early September. With rates this high, equities in a rising wedge rallying on no volume, the USD almost back to 2008 lows and commodities having outpaced equities since their bottom, a massive decline in equities and commodities starting in August-Septemeber seems to be the play. An October crash scenario repeat of last year is far from being out of the question. Meanwhile, bonds should surge, rates should tank, the USD and JPY should fly, and the EUR, AUD, GBP, and CAD should drop like a rock.
The variable here is how gold will perform. The United States' deficit spending and debt monetization has caused bondholders to sell duration and leave Dollar-denominated debt and the USD in mass waves. As the safe haven trade makes an encore this fall and winter, it will be interesting to see the proportion of equity and commodity outflows that go into precious metals instead of USD and Tsys.
In my opinion, we have reached a disconnect between "smart" and "dumb" money actions, as far as safe haven perception. Obviously, the deleveraging wave this fall will provide massive demand for USD, but the more relevant demand in context of this article is for risk asset outflows for safety. The money leaving stocks for bonds is feeding a bubble that can only result in the ultimate Black Swan, that of a bond implosion.
Though game theory/MAD would never allow for a hyperinflationary, triple-digit interest rate scenario in the United States (though America's fiscal and monetary policies may warrant such an occurrence in a vacuum), the mass influx into Tsys offers a frightening picture of herds moving into essentially toxic assets. Once more debt starts being monetized, excess reserves are unsequestered, price inflation creeps in, and debt inflation wreaks havoc on real interest payments, the resulting picture is of a crowded trade gone terribly wrong.
It is then that precious metals may get bubbly and today's "smart money" buyers may become sellers.
But at present, the picture remains deflationary and deleveraging dominates. Rates are too high for continued recovery, the USD is falling off a cliff, there is no revenue growth or CapEx improvement, and unemployment is rising. The equity and commodity markets are pricing in absurd levels of growth, and the demand is not being offered by perception of economic growth, but rather by Fed-gifted excess liquidity that is inherently buy-biased.
So if you were the Fed, given current conditions, what would you want? Would you want rates to keep rising and the credit reflation to fail? Or would you want rates to go back down, and leave the taxpayer holding the bag as the retail investor who bought the record levels of debt and equity issued into this rally? Would you want rates to sustain their current trend and China and Japan to offer a mass exodus from bonds, preventing any attempt at debt rollover to continue deficit spending? Or would you want to bring creditor nations back into panic mode, buying your bonds and leaving them the bagholder for your toxic securities as you monetize your way out of debt?
Excess liquidity is a funny thing. It is nothing but pulled-forward wealth looking for a present-day home. The ballooning of the Fed's balance sheet has been sequestered as excess reserves thus far, most likely actually ending up as proprietary trading buying power for banks. But when these excess reserves come flooding into the economy, expect the next sustainable bull market in commodities to begin, through inflation.
Right now, the excess liquidity is chasing equity beta; it is momentum-chasing, positive-feedback, and causing a rally anything but durable. When this liquidity reaches the real economy, the lending and spending level, is when the pulled-forward demand represented by the liquidity causes nominal economic growth to allow corporate revenue and earnings growth to support an equity bull market. When will that happen? When the excess reserves are unsequestered, when this chart shows a new uptrend:
Until then, the Fed's mass printing will only be used by bank prop desks to chase high-beta equities and keep a constant bid in the market... Until the liquidity dries up, the stock market plunges, Treasuries rally, and the Fed once again has the political capital and further room in the USD to fall to print more. And eventually flood the economy with the excess reserves all the printed money is going into. When this happens, expect the next home for excess liquidity (bubble) to manifest itself: gold.
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.. following "smart money" has now come to mean following those in-the-know of future government actions, or at least those with high predictability or involvement.
Heck, Bill Gross said the same thing during Q1.
The fact remains that the Fed and its member institutions, including the US Treasury will continue to do everything in their power to blow bubbles. They have no choice if they want to keep their corrupted power.
sleazy linking practices; borderline fraud ..http://www..
hat tip: gay porn and deceitful, slimy operators
OK ,
Everyone who just missed a 3,160 point rally in the Dow Jones Industrials write a verbose article with polysyllabic gibberish invoking John Nash, Game Theory or something cerebral to cover up the fact that they blew it.
By the time it prints 10,000 everyone in shanty town gets a Ph.D.
I missed the rally. I also missed the crash that preceded it, by being out of the market since 2007. I've been buying gold since 03.
Some people (like me) don't have the time or inclination to be joystick jocks. I take long-term positions, usually for 5 years or more, and add to them over time. I'll probably be in gold for at least 5 more years.
I leave the gunslinging (and capital gains tax-paying) to cowboys and just make money. What's your return over the last 10 years? Mine is pretty good.
Actually, you're still down 28% from January
2008 despite the 55% rally from the March low, so it's more
likely that you blew it.
some very simple and fairly well-known indicators (inverted yield curve, MA of advance/decline ratio, 200SMA) signaled cash in late 08. Then back in late March/early April. So missed the major carnage then caught most of the rally. A couple points of whipsaw ... but minor.
VWAP REDI SONAR versus "some very simple and fairly well-known indicators (inverted yield curve, MA of advance/decline ratio, 200SMA) signaled cash in late 08"
I had a quick look at the balance sheet for the ESF and I am not sure you are on the right track. There is a story here and I suspect that it relates to the 1.75 trillion of GSE Securities held and to the fact that foreign currency assets have increased due to currency deposited with foreign central banks. By my calculations the ESF had increased its assets by 2.5 trillion, but this looks complicated by changes in the special drawing rights.
http://www.ustreas.gov/offices/international-affairs/esf/congress_report...
Market sceptics had a good article about it a while ago which got into a convoluted discussion whether the Treasury was forcing the FED's hand with the ESF and how a certain bank which curbs shorting is involved. Having looked at the numbers myself now I am less than convinced, but see no reason why the ESF could have been used to manipulate the market as it does not have the same restrictions as the FED.
www.marketskeptics.com
Now if you could just front run those GSE purchases you would make quite a profit on fixed income, let alone front running QE. Re-capitalisation through the back door as Meredith Whitney put it which steals a little from each mortgage payer.
The scenario presented in this article is the exact same one that I subscribe to.
Fed-induced equity collapse leading to bond rally to save yields and, secondly, to provide the buyers for Obama's Stimulus 2.0 (to be announced).
I think China is the key here. The current path is the 'soft' option, palatable to the locals but not appreciated by foreign holders of Treasuries. It works fine so long as the bond vigilantes don't make an appearance.
The Fed will push the envelope on the soft option before it is forced to implement a hard option (as described). A key trigger is China losing patience and dumping Treasuries.
Bernanke has a few plates to keep spinning here. Run fast enough between the poles and it can be done.
'Crashes' rely upon the Fed failing to spin the poles regularly enough.
- Mediocritas
One thing is for certain: The definite End Game (whether hyperinflation or deflation or stagflation) is at the very minimum a decade of malinvestment and forsaken true economic growth.
When I look at this from a game perspective it seems like those that were going to sell did so at some point b/w fall '08 and spring '09. Even though the market is pricing in all kinds of go-go economy and most sceptics (me included) think that the market is too pricey, corrections require sellers. A lot of them have already left.
Can we really expect to see more of them until revenue/earnings for this quarter start to be reported in October? I would certainly welcome it.
Forget game theory. We are all kremlinologists now.
"Since QE wasn't extended, the last POMO date scheduled as of now is in early September. "
The 300 billion program to purchase "longer term" treasuries is but a small portion of the POMO.
http://www.newyorkfed.org/markets/pomo_landing.html
The big liquidity from the POMO is the 1.25 trillion in Agency MBS purchases, which are scheduled to continue through the end of the year and of which (I believe) @ 500 billion are left.
This obviously dwarfs the Treasury purchase progam.
On Wednesday, March 18, the FOMC announced the expansion of the Federal Reserve's program to purchase agency MBS to a total of $1.25 trillion by the end of the year.
http://www.newyorkfed.org/markets/mbs_faq.html
I was just about to post the same thing. QE was not stopped by any means. Treasuries is a sideshow relative to the main event of MBS. Why do most people miss this? Let me answer my own question: because 99% of financial market participants don't understand the MBS market.
You are correct, they still have about $500B of MBS to buy by the end of the year. That is a LOT of liquidity to hit the markets.
As a young market participant where would I go to learn about it?
Exactly. QE is not going to stop, the Fed just dresses up the same pig in different outfits and throws a few smokebombs to keep people from seeing where the target really is.
The Fed taking control of open positions from major defaulters (esp AIG), in order to prevent a cascade taking out entire global derivatives market, keeps the gambling ring in operation but it busts the zero-sum nature of the system. The result can only be inflation somewhere and we're seeing it in the most obvious place: equities.
yes the derivatives are the ultimate driver of
all financial decisions and manipulations of the
fed....derivatives dwarf currency, equities,
gold, debt and all else combined by orders of
magnitude.....everything is geared toward keeping
that helium inflated elephant afloat without
a credit event...
"The only option for the Fed/Treasury is to somehow spur organic demand for USD and Tsys. Nothing like a crash in equities and commodities to do that."
To that would add yet another crash in commercial and residential real estate, gold and silver.
Born again bank believer Meredith Whitney provided perfect cover from Jackson Hole Kansas City Fed with BB:
http://www.youtube.com/watch?v=taHheGtjvSc 5:50.
and now you know why there is a disconnect between economic fundamentals and market behavior.....it's all quite rational when you introduce the 1.5t usd of money flooding equities markets and is the effect of monetary inflation.
this is what fuels the gs sparc stations.
soon the money will seep into main street....
it's also another reason why bernanke, geithner, paulson, bush and obama should be in jail.
via TheStreet.ca this link to a free online course from Yale on Game Theory
http://oyc.yale.edu/economics/game-theory
While I think most of us can be agreed that the equity rally has contributed to the problems you mention as motives for a Fed-induced equity crash, I think it's fair to question the assumption that tanking equities is the way the Fed would achieve its goals. For the author, then: What was the intention of what the Fed & Treasury has done to date? Presumably much of the equity rally we've undergone was a deliberate intention of these entities. Is your idea that it was simply overdone, and that they need to pull the reins back in order to meet their other goals? Or what?
Rates where they are are just fine. I doubt there are not many out there eager to borrow except they need rates a bit lower. I am talking real brick, morter and employee business here by the way.
A real equity crash now would be a disaster. It would be insanity to encourage or even want a severe stock setback now just to lower the Treasuries borrowing cost a few hundred million over the next couple of years on upcoming supply. Better to hope that Behavioral Economics works and the revenue starts returning to the Treasury.
Gold ain't gonna work if the equity market tanks again. Gold will be trading 750 - 850 if the S&P sells off 20%.
Somebody said the same thing in 2002.
Hard to understand how so many people can miss what Bernanke has explicitly and repeatedly mapped out for all the excess reserves he has printed up and parked at the banks: They are/were not - now or ever - for the purpose of creating useable liquidity (though they've served a propaganda purpose that enhanced other actual liquidity-creating moves). Their explicit purpose was to provide the missing capital for banks'account books in order to make them solvent (or at least less insolvent), so the FDIC wouldn't have to shut them down. The mechanism to insure that they wouldn't enter the liquidity flow of the real economy (unless there was actual earth-shattering liquidity crunch, which there hasn't been so far) is the interest rates that Bernanke got Congress to authorize the Fed to pay on those excess reserves. As long as banks get that interest (which is the single most secure form of income on the planet Earth) the reserves will remain "excess" - they will never be used to make loans, or otherwise enter the economy. They have served their initial purpose and drastically slowed the bank failures (without this move, we would be looking at over a thousand failures so far, with more to come). But wait, there's more. As Bernanke has explained, now the Fed has choices it didn't have before (that's why ZIRP is not a boogeyman for him on monetary controls). They can let the reserves be released (by stopping the interest payments) in event of the earth-shattering liquidity crisis mentioned above, or they can keep the reserves frozen in place in an inflationary rising-interest-rate environment by raising the interest rate they pay on the reserves. They can even drain the reserves slowly at some fanciful future date when the late great recession is over, banking is solvent again, and the economy is overheating. If you want to know what the Fed is doing and where they think the economy is going, don't worry about Fed Funds rates and QE, watch the excess reserve policy and practice.
someone gets it!
the mbs purchases are a horse of different color -
much of that money has seeped into the stock
market...not sure if that was by design but
the stock market had to be levitated because
so many funds - i.e. insurance - which are
invested in the stock market would have tanked
if the markets stayed below 8000 for long...and
those firms would have to be shut down by
regulatory decree....
ben is juggling balls which keep growing by
the rotation...
"Their explicit purpose was to provide the missing capital for banks'account books in order to make them solvent (or at least less insolvent), so the FDIC wouldn't have to shut them down."
Really? When all the banks have to do to remain "solvent" is to cook the books courtesy the FASB and the FDIC is toothless puppet of the money center banks?
smoke and mirrors goes only so far...at some point
you have to show the goods.
Correctly stated but who finally pays for the tens of billion in interest that those big banks gain as a means of Fed rewarding them for trashing the economy and for keeping their garbage under their carpet?
"Though game theory/MAD would never allow for a hyperinflationary, triple-digit interest rate scenario in the United States"
--^ Why not?
Agree with most everything else. But in my opinion, precious metals are far from 'bubbly'. When the crap hits the rotating blades, all offers to sell gold could be withdrawn as gold goes into permanent backwardation (spot above near futures). This of course would be a major problem as it would indicate system failure and would contract global trade. Yes if equity market tanks gold could go back down to 800-850, but if there is a 'currency event' (an increasing possibility) , all bets are off.
--------------------
"
What does it mean for a bullion bank to fail? Just as a regular bank would fail from a massive withdrawal of deposits beyond its ability to pay, we could say that a bullion bank has failed if it can't supply the gold necessary to honor its obligations. You can be sure it will first exhaust itself by trying to obtain whatever gold can be obtained on the spot market to fill its obligations prior to failure as an institution. But this is where the price would race away on the spot market paving the way for a complete run on all physical gold, permanent backwardation in the forward gold market, the withdrawal of all offers to sell physical gold, and a complete failure of the spot market to exchange gold for dollars at any reasonable price. And so, we would have the official failure of the dollar as well.
This is how a failure of the paper gold market, a DEFAULT on paper gold, will mean the collapse of the dollar. You will have the dollar on one side, gold on the other, and COMEX contracts in between the two of them. This will essentially pit gold and the dollar against each other, forcing them to arrive at a settlement in a dollar-rich/gold-starved arena. Could the dollar ever deliver on its physical gold contract obligations? No way. Which do you think will be left standing?"
http://fofoa.blogspot.com/2009/08/confiscation-anatomy-different-view.html
speaking of bubbly, gata just published an
interesting short explaining why current gold
production is uneconomical...the implication is
that we can expect continued declining production
and price increases....
although there may be some notable
exceptions provided that the gold producers have
hedged properly and many producers have
depreciated costs on older mines it seems that
the supply trend is away from lower prices...
Obama's re-appointment of Bernanke would be crucial - if Summers is given the job, then the focus would definitely not be nominal economic growth but more profits for the banks. Not that Bernanke would do anything to prick the stock bubble, but the bias definitely would be to find ways to divert some of the QE liquidity from prop desks trading into the real economy to avoid several Japanese lost decades. Bernanke did not want to preside over another great depression, by extrapolation, he would want to avoid presiding over the greatest stock market crash of all time, AND 2 lost decades a la Japan.
"The only option for the Fed/Treasury is to somehow spur organic demand for USD and Tsys. Nothing like a crash in equities and commodities to do that."
Its not the only option. Perhaps it escaped your notice that since early June, Treasurys have risen together with equities. In fact they can have the pie and eat it too because there exist no free markets anymore. Your equity crash scenario is IMHO highly improbable for the next two months.
No despite what the fed says it wants to kill the dollar. clearly that is the plan and to induce futire inflation. this suits the interst of wall street and out huge amount of gov't debt.
It was going well until your main conclusion was profferred: that equities should tank to offset the indeniary inflation-trade. Much as i'd love to profit from that, i cannot bet on it, but only in the slightest of increments. if there is one thing that this crisis has proven to me, it is that bernanke wants nothing more than to have inflation as something to worry about -- so long as it comes with some job growth. Since this socialist administration took office, NOTHING has been more important that pumping the stock market: from Obama telling you to buy stocks, to Summers and Geitner gaming the weekend risk premia while holding Vikram Pandit's hand.
But indeed, one would be a fool not to expect some real selling at some point, if only because the government will want to make their tax receits for 09 adequate. But a true 'crash' will in NO WAY be predictible in its arrival or duration. It could happen in early 2010, or perhaps the fall of the 2010 for all we know. but i always remind myself when considering hitting the down tick that: THEY WILL PROP THIS THING UP NO MATTER WHAT...THEY've COMMITTED ONE TOO MANY ALL-INs to let it all melt. Sure we might get a 10% correction, but even that seems like too much for 2009. I'd be a very careful bear if i were you. And please do not mistake me for someone who actually profits from these bastards games. Based on the patterns since last fall, however, these are my conclusions, which are somewhat antithetical to yours. -V.
The phrase "Japan's Lost Decade" forcefully implicates you (us) in supporting bubble economics. The only thing Japan lost was a class of speculative investors who contributed no tangible benefit except to themselves by manipulating capital markets for personal gain. By suckering independent investors into a fools bet, manipulators used the legitimate capitalization and valuation of real businesses as an ATM machine.
If you're implying that Japan lost something of value by returning to a predictable and boring long-term aggregate growth standard, then send your resume to GS, I hear they're "the smartest guys in the world".
For the sake of argument, can we stop using this phrase to imply that Japan would be so much better off if only they had institutionalized the Craps table? Lost Decade? We should be so lucky.
It's hard to be certain about many things, but one thing is for sure - regardless of what happens in real life, US Gov fantasy land will go to great lengths to protect the perceptions of the US public. There's no faster way to a revolution than leaving the middle class hopelessly depraved.
You can shear a sheep many times but skin him only once.
My view is that the bubbles - dot com, property, commodity - were designed to bring China down, ignoring the plight of the rest of the world and the US citizenry. If one reviews history in outline the US has used the same modus operandi several times to deal with its opponents. In the late 1980's a global inflationary bubble was erected, which was especially felt in Japan. When this bubble was collapsed it took the Japanese down. They also experienced marked rallies on the way down that died as the market slid down to its lows. The next crisis was the Asian financial crisis when the Asian tigers were promoted as the place to make money. Hot money flowed in and at some point was removed along with a speculative attack on the various asian tigers currencies. Commodities collapsed especially oil. Russia collapsed as a result of the low price for its main export - oil. Fast forward to now and we have a similar position in China. It experienced the full thrust of the huge build up courtesy of the property bubble that went global. When the GFC hit, the Chinese leaders panicked and unleashed their bank lending, which has gone into the stock market and property market yet again. Currently they are trying to cool this latest bubble. If there is a global market rout and money moves into the US dollar and US debt issuance, this solves the problem of selling the debt, and the problem of the US dollar being toast with the debt issuance. It also takes China down further. There are big celebrations planned for October commemorating the 60th anniversary of the founding of the modern communist state. I suggest that the US would love for nothing better than to cause an economic dislocation in China of such severity that there was civil unrest in the streets and destabilization of the system.