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Friday August 3, 2007 - 12:46:19 GMT
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Currency Currents

FX Trading – Jobs Friday! A perverse theme.

Two US$ rally scenarios on July jobs report due out today in the US:

1) Growth: We see good jobs report number – This, coupled with the latest better than expected advance GDP report, might shake out some of the still very bearish sentiment and trigger a decent move.

2)  Perverse: We see a bad jobs report number – This would indicate subprime is biting into the real economy and could trigger additional fear, driving more of the risk-reduction trade we’ve seen of late, which has been bullish for the dollar. 

Let’s work off of perverse scenario number 2.  We’re often asked:  How can you be the least bit bullish on the dollar given the US economy is in such trouble?  It’s simple. 

First you have to remember that it doesn’t matter if the US economy is in trouble (still and open question); what matters is money flow.  We live in a free floating currency world.  That means currencies rise and fall based on simple supply and demand; with some minor wrinkles of course.  It’s likely that a disproportionate number of recent Ivy League finance degree graduates, who of course were ready to run real money right out of the box (just ask them), are likely now running hedge funds.  We know many of those hedge funds are quants who have been doing lay ups with massive liquidity and impressing said investors.  So, we have a bunch of funds being run by a bunch of people who don’t have any grey hair yet.  Thus, many may still be hubris-filled, to put it mildly (running a hedge fund and Ivy league status, probably golfers and bottled water drinkers to boot—we’ve seen it all before).  Bottom line: Many don’t know enough to be afraid—and they should be very, very afraid of what’s happening in the background. 

To steal a phrase from Ross Perot (my former boss many moons ago, by the way), that giant sucking sound you hear is liquidity draining from the system. 

We are fast reaching a stage at which elegant quantitative models won’t determine who survives, in fact, those that tend to rely on models in this environment may be most likely to be shining shoes sooner rather than later.

F.J. Chu reminds us that markets are not about models:

“Those who wish to render the market rational and susceptible to mathematical quantification misunderstand its true nature.  The application of probability, statistical regression, and diversification only gives the sense and appearance of control.  Yet in their search for certitude, they reflect a pessimistic confusion about the economic future and its limits.  We cannot drive absolute certitude about the market because it has its roots within ourselves.  The market is not illogical per se, but its mathematical exactitude is a trap.  The market is governed by laws of the mind.  Insight, imagination, and faith—and not just economics and rationality—are the sentiment that mobilize the investor to risk his capital.  After all the research is done, the wisdom of his actions will not be apparent until well after the investor commits himself to it.  An investor must trust his intuition enough to pursue his vision and act upon it.  And in doing so, he carries the insecurity that comes from standing alone and not with others.  In most cases, a reasoned calculation of gain or loss would impel an individual to the sidelines in search of security.  Investors who never act until all the market statistics are available or wait until all speculation becomes fact are doomed to mediocrity by their dependence on an illusory rationality.”

Two important points here: Quants by nature put faith in mathematical exactitude.  And as much as they guard their respective “models”, they still tend to herd i.e. take the same trades, kind of like a pack of hyenas swarms a dead carcass. 

Markets are inherently unstable.  The idea of market equilibrium seems farcical.  Maybe markets tend toward equilibrium, but the interesting part is that those who put their faith in mathematics, especially the mathematics of derivative manufacturing, see it as a stabilizing force for the system.  That is either self-serving or completely out of touch with reality.  Did financial derivatives innovation create the excellent business cycle or does an excellent business cycle make financial innovation look better than it really is?  Why should we stand in the way of free market innovation?  It has to be good, right? 

“Innovation is regarded as one of the main benefits of free markets, but because financial markets are inherently unstable financial innovations may be creating instability.  We ought to view financial innovations differently from the way we view better mousetraps and other innovations.  This will require quite an adjustment, because the best brains in the world have been attracted to the financial markets and the combination of computer capacity with efficient market theory had produced an explosive growth in new financial instruments [Soros never could have guessed derivatives would grow to 760% of global world GDP back in 1998 when he penned this] and new types of arbitrage.  The dangers that they may pose to the financial system have been ignored because markets are supposed to be self-correcting, but that is illusion.  The innovations and techniques are not properly understood enough either by the regulators [definitely not by the ratings agencies] or the practitioners [read recent Ivy League finance grads]; therefore they pose a threat to stability,” writes George Soros [he is wearing his macro global investor hat here, not his political one.  There has been no one better, ever, when it comes to global macro analysis, in our humble opinion, than Soros, despite our disappointment he has become immersed in politics of late.]

So, the perverse dollar rally argument is predicted on two themes:

1) Derivatives will create a whole lot of instability; especially when the hubristic types running quant funds finally realize math can only go so far; and
2) When the herd runs, instead of jogs, to the exits, a wall of money just might flow into short-term US Treasuries.  And the last time we checked, short-term Treasury paper was still denominated in the lowly US$.

Enjoy your weekend and be careful out there.

Jack Crooks
Black Swan Capital



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