January 8, 2014

Great Expectations

Happy New Year! Hope you spent the two-week break from these pages joyfully.

We’ve descended this week from the high Denver backbone of the continent to visit west in Santa Monica and sponsor NIRI’s Fundamentals of IR program. Following our New York trip before Christmas, we’ve marked the turn of the calendar by touching both coasts.

We’ll kick off the year with a story. I’ve just finished Charles Dickens’s Great Expectations on my Kindle. Yes, I realize it was first published in serial form in 1860 (the year the cattle ranch on which I grew up was homesteaded). I have a long reading list. It took me awhile to get around to it.

Lest I spoil excitement for the other three or four of you planning on it still, I’ll say simply that it’s a masterful narrative assemblage of plot points, the connections between which one would never fathom at the outset. Great storytelling never gets old.

The market is like that too. As you begin 2014 in the IR chair, remember that in a market dominated by algorithms – the principal purpose of which is to deceive – things are rarely as they seem.

Take trading from Dec 9-31, 2013. The US equity world it seemed was gathered in knots and pockets like people in an old west town where the gunslinger was expected anytime to ride through. Tones were hushed, gestures animated. A pregnant air of expectation hung like a storm.

Would the Fed finally taper? And if it did, what then? 

Starting Dec 9 like the first fat and splattering drops of rain, a vortex of volatility halts in commodities derivatives commenced. With names like iPath Pure Beta Grains ETN (ticker: WEET) and the Oil Futures Contango ETN (OILZ), exchange-traded instruments that help investors and risk managers play commodities volatility, suddenly turned topsy-turvy. We tallied hundreds of these halts into the end of December.

It’s a puzzle piece in Dickensian fashion, a building-block to narrative. Traders and risk managers were betting on a taper of some sort, affecting commodities. Moves began beforehand to shore up exposure, and the effect, perhaps unintended, was gyration in derivatives.

On Dec 18 when word came that the Fed would take $10 billion away, markets first balked and then soared, rising handsomely into year-end and defying expectations. If the market had tilted like a pinball table on mere whispers in May and June, why would it soar on actual words?

We see data as a story. We read on. The Fed daily lends all manner of government securities. Dec 19-20, the Fed made a combined $2 trillion worth of securities available for borrowing, which seems big until you know that $750 billion is normal. Just a small part is consumed, about $10 billion daily. Traders borrow and probably sell that sum to raise cash for trading purposes. Borrowing costs five basis points generally (yes, five-hundredths of a percent). Use of this window soared 45% to nearly $16 billion daily from Dec 9-31.

At the same time, we observed a massive decline in short equity volume – trades marked short for the day. The plunge was on the order of 25% marketwide.

Finally we looked at what was setting prices in equities. We statistically monitor fluctuations in buying and selling by indexes/ETFs, bottom-up investors, fast money, and hedging. The only two price-setters in equities by these measures from Dec 9-31 were fast money and risk-hedging.

Together, these vignettes weave a plot. Traders and risk managers borrowed securities from the Fed and sold them to raise cash, which was used to cover short equity-exposure (perhaps in swaps more than in open markets), which drove equities up strongly.

This picture fits what we hear from pundits, save for one piece. Borrowing Fed securities and selling them means traders think bonds will weaken and interest rates will rise, and short-covering means stocks are expected to do best. No surprises here.

But it wasn’t investors buying stocks. It was risk-managers and speculators, a whale-sized form of straddling outcomes. Borrowing spawned it, and gains for stocks resulted from shifting borrowings.

Seeing reactions last year to taper whispers, maybe the Fed reverted to its habit of encouraging borrowing, a defense against a shock. But what limits long-run growth is borrowing. So I’m not sure we should have great expectations.

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