December 9, 2011

Arbitragers Love Monetary Intervention

Say you were playing poker.

I don’t mean gambling, but real cards. You’re engaged with some seriousness. You’re watching how you bet and when, reading the players ahead and after you.

Then The House starts doling out stacks of chips. Would you play more or less cautiously if you had free chips?

Apply this thinking to equity markets, IR folks. In trading data, we saw European money sweeping into US equities Nov 28. Why did markets trembling Nov 25 decide by the following Monday to up the ante in risk-taking? Primary dealers implementing policy for global central banks also drive most program-trading strategies.

Thus, European money surmised that central banks would intervene, and their behavior reflected it. The rest caught on, and markets soared Nov 30 on free chips from central banks. It was short-lived. By Dec 2, we saw institutions market-wide assaying portfolio risk and locking in higher derivatives insurance. The chips were gone.

Money sat back expectantly. On Dec 8, The House delivered chips as the European Central Bank lowered interest rates. That’s devaluing the euro. At first, cheapening the euro increases the value of the dollar – which lowers US stocks (a la Dec 8). But if you’d hedged with derivatives as most of the globe did, you bluffed The House. Plus, the Fed will likely have to follow Europe’s bet up with a see-and-raise to devalue the dollar back into line with the euro (expect it next week, but before options expirations).

In poker, having “the nuts” is holding the best cards, and knowing it. Central banks have given arbitragers the nuts.

Arbitrage is a buy-low/sell-high strategy that depends on gaps. Say you’re in rush-hour traffic and all the cars are packed together and then a little gap forms and somebody shifts over from another lane. That driver has just arbitraged lanes of traffic. Now suppose suddenly a new empty lane materialized?

That lane is a stack of free chips in poker, or monetary intervention. A windfall. Global statistical arbitrage is money in planetary slosh after gaps. Remember, money can trade your equity, your options and Treasury futures in one fell swoop, in seconds or less. Or any random collection of electronically tradable securities from here to Stockholm.

Gritty rational money has bought growth issues, too. If inflation in equities is likely because The House may wander through with more free chips, that’s “growth,” not value (but is inflation growth? Hm.).

Generally, arbitrage makes life difficult for thoughtful investors. Investment certainty requires a fair and simple game. You buy in, you play your best, you win or lose. No free chips from The House.

So expect arbitrage. Expect volatility.

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