Saturday, May 12, 2007

Common myths of the market

I think some misperception of hard facts is going to stop many otherwise sensible traders from making money in the markets this year. Let me clarify some of these.

Common myths of the market:
1) the dollar is weak
2) energy prices are soaring
3) inflation is high and out of control.

Re: 1) The dollar is actually STRONGER (albeit just) than it was against the Euro in late 2004.

Re: 2) Oil prices are only ~10% higher than they were in October 2004, and are down significantly from the middle of last year.

And in that time period, average incomes must have grown (5-10% total at a guess?), the stock market is up ~30%, and GDP has averaged about 3% annually. Not that bad I reckon.

So maybe there isn't a ticking time bomb anywhere waiting to crash the markets, merely a normal slowing economy that we have had many times in the past. If you believe in Occam's razor that the simplest solution is often the correct one, then the most likely course of action in a rapidly slowing economy is to cut rates. Looking at the chart of US GDP to Fed Funds Target rates between 1985 and today, it's very clear that the Fed's target rate is reduced in response to falling GDP numbers.

Now, what do we have in today's market? Yep, falling GDP. And from 1) and 2) you can see that the dollar isn't collapsing, merely at the weaker end of its medium-term trading range, possibly because the market is pricing in the fact that the Fed will be cutting rates in the near-ish future, and you can see that energy prices actually aren't out of control at all, so no signs of "hyper-inflation" anywhere. That leaves the Fed with room to cut. Yet the market is barely pricing in a single rate cut this year, and only pricing ~2 rate cuts through to the end of 2008! See the Eurodollar rates here (if you aren't familiar with this, the rate column is where the market is pricing 3-month interest rates on the dates shown...slightly different from Fed Funds, but tracks it fairly closely, and over the long-term has traded ~10bps higher than the Fed's target rate):

So what's the trade? It seems just too easy and Eurodollars across the curve. I already own some Dec '07 contracts at 94.905, and plan to buy some Sep '08 or Dec '08 contracts next [Update May 15: Just paid 95.21 for Dec '08 contracts]. The Fed could easily trim rates to 4% by early next year, so these contracts could soar from here.

Oh yeah, I'd nearly forgotten about point 3). You think inflation is too high for the Fed to cut rates? Then what do you think of this chart from 1985 to today showing Fed rates versus Core CPI yoy:

Yes folks that's right...if the Fed was to cut now, CPI would actually be much LOWER than at the start of almost all rate cutting cycles in the past (I believe this holds even if you go much further back in time, it certainly does on Bloomeberg where the data goes back to 1970). Rate cuts here we come, make sure you profit from it, cos it seems to me most people are gonna miss this one.

It was commented on that I had picked the EURO to highlight my case, whereas I should have used the Dollar Index ($DXY)...well, here it is...again, the dollar is stronger than where it was in late 2004 (and early 2005), and if the Fed were to cut rates, who's to say it wouldn't rise on future growth prospects for the US?

Addendum 2:
There has been some come complaints that Core CPI isn't valid (ie ex-Food-and-Energy), since Food and Energy are rising more rapidly than Core Inflation...and sthis may stop the Fed from cutting. Well, here's the graph, of Headline y-o-y Inflation versus Fed Funds. You can see that Headline CPI is lower today than when the Fed started cutting rates in 1985, 1987, 1989, 1996 and 2000. I think this invalidates the "but REAL inflation is too high for the Fed to cut"...

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Anonymous Anonymous said...

the complaints are usually from the Tin Foil Hat crowd of conspiracy theorists

16 May, 2007 01:29  

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