Market instability is good for us

I read an article in the FT last night that got up my nose but made me think. The article was in the Alphaville section and was headlined “The Euro is tracking commodities” and the premise was that the EUR,

seems to have detached itself from interest rates and its own fundamentals

Really, you have to be kidding me. EXCHANGE RATES ARE BILATERAL – that means that we compare not only the EUR and its zone but the US and its economy when working out the EUR/USD rate. There are studies that show that at various time one side of the cross or the other dominate but that its not always one side.

This kind of weak thin slicing analysis really gets me going, as you can probably tell, and I don’t like to play the man/strategist instead of the ball but this is rubbish with a capital R. The EUR is trading with commodities because they are all trading off the USD as the market tries to figure out if the USD has based or not. On its own fundamentals the EUR is getting smashed against the Swiss Franc, Australian Dollar and even the British Pound which is confounding. But then again Britain is just economically moribund it doesn’t have 4 or 5 bankrupt states that it needs to succour for a generation or two.

But the good thing about this article getting me riled up was that it sent me off on a thought tangent. My own little Gedanken experiment if you will indulge me the licence.

Now my basic premise when it comes to the economy is that it is made up of people, they are not the rational actor of homo-economicus but in total all these people form a complex adaptive system which learns and grows and has interconnectedness. That’s why history rhymes not repeats – while the drivers may be similar the results aren’t always the same because people and the economy learn.

It is the adaption and learning phase of a complex system to which I want to address today in the context of Greece teetering toward default and posit that all the recent instability may be a good thing. The cross currents in markets at the present are amazing in their complexity and interestingly what I thought was a growth in the fingers of instability and so a massive threat may actually be supporting things.

But first let’s look at what’s going on.

In Currency Land the USD’s rally has faltered letting the AUD, NZD, EUR and other currencies off the mat they were on earlier in the week. Underneath the surface however the EUR itself is extremely weak making an all-time low against the Swissy (CHF) and back toward its lows against the AUD. As I noted above it’s even weak against the pound. What we have seen recently with the volatility that accompanied the USD’s recent low and turn is position squaring and what we’ve seen lately is trading not big positions being bet.

Over in Bond Land we are in the midst of a big fall in outright yields on US 10’s and shorter maturities while at the same time CDS spreads for Europe are blowing out. Corporations are issuing well inside some of the sovereigns around the world and Chrysler, having been saved by the US Government, now seems to have a healthier balance sheet than Uncle Sam. European banks, particularly British, have been able to issue in Australia and there seems to be a sweet spot where investors have demand for a wide variety of names not just the usual offerings. This lowers the concentration of risk inside portfolios

In Equity Land we have froth and bubble for new issues like LinkedIn which is still very high (USD 86.37) compared to listing while other companies are in the doldrums and indices broadly are under pressure. It’s not exactly ebullient and while the market is not climbing it, there is a big wall or worry in front.

In the land of Commodities where men wear 10 gallon hats and multi-billion dollar fortunes continue to be made prices might be off a touch but are holding in even as the global growth profile weakens.

All in all the market, as a whole of these subsets, is all over the place as traders play the individual segments they know and the big “macro” bets seem less prevalent than they have been over the past couple of years.

My little gedanken machine thus suggests that this could be a really good thing.

Here’s why – the biggest risk from a Greek default, which European politicians are both denying and causing, is of contagion and instability in other markets. But like a bushfire here in Australia, contagion needs fuel to feed it and spread it. My hypothesis, which as I said came to me overnight and is not completely formed, is that the fuel for contagion to become an all engulfing global bushfire is correlated market bets. That is everyone is trading with the same approach and from the same angle. But the price action over the past week or more, indeed longer, suggests this is not the case.

Traders and Investors have learnt from their 2008 experience. They can see the competing forces of a weak US and weakening and threatened Europe. They can see the Greek default coming, they know this week’s G8 conference is a meeting of the old guard as the axis of power shifts and is shifting to the BRIC economies and they know that to stay in business and make money their approach must change. In some ways I’d argue that traders evolve faster than the average member of the population because they have too.

So while there is a large element of USD in trades at the moment the overall instability in the globe over the past few months may have been like a winter burn off and actually fireproofed  the globe (or at least reduced the fuel load) when Greece ultimately defaults. Time will tell and I’ll need to think about this some more. Any thoughts welcome.

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