Where did all the volatility go?!

I know that the VIX family is the staple to measure volatility. The way how this index is derived is through the (in)famous Black-Scholes formula, i.e. for a particular asset it is a function of three variables: its current price, the price of an option based on this asset, and the expiration date of the option. The VIX-like index dedicated to the currency market is the EVZ which gives the implied volatility for EUR options priced in dollars. For the last week this index has dropped from 13.3% to 11.6%, which I think does not capture at all the dramatic lack of volatility in the Forex that we saw Wednesday through Friday.

The easiest way to see what I mean is to look at the price of the dollar against the EUR 8:29 on Friday, 1.487. At 8:30 came the unemployment announcement, expected unemployment rate 9.9%, actual 10.2%. The response of the EURUSD rate was almost nonexistent--for the rest of the day it traded in a range of 30 pips.

That is spectacular!!! The first explanation that comes to mind is that the market had priced the unemployment announcement prior to the data release, which is kind of doubtful. The highest number from the pole that Bloomberg did before the announcement was 10.1%. The other explanation---a black whole sucked the volatility out of the global markets (here I am also referring to the tame response of the S&P500) and there is not a single bad news that may come and change this. A better name for this particular phenomenon is optimism, a filter that processes thirstily any good news and dismisses fast any bad one.

After two years of either loosing money or sitting on the sidelines with a pile of cash, the investors (strange predators with not necessarily rational habits) want to be back in the game. The FED is throwing a funding extravaganza and nobody wants to miss the party. Hangovers are in general easily forgotten (ask any college kid), so it doesn't seem that there are a lot of designated drivers in this particular party.

So the question is when will the market start to listen to bad news again. I mean the broader unemployment index is 17.5%. In an economy that depends 3/4 on the consumer, the unemployment cannot be ignored for a long time. One of the possible party pooper events in the near future is the holiday shopping season. Lets wait and see.

Felix Salmon on the dollar carry-trade

Here is a nice comment on Roubini's "mother of all carry-trades" claim.

No need to say how much I agree with this. I was the first to point out how unnatural this carry-trade situation looks like.

Here is my comment on Felix Salmon's post:

There is something unnatural to borrow from a country that is a net borrower itself. This kind of financial flow will have to be reversed sometime in the future. Where you may have had gradual build up of short dollar positions, once the trend is reversed, even by a small amount, the dynamics of the system can change significantly. That is, nobody likes to be the last person out, so the pure momentum of people rushing for the exit, first for locking their profits and later for cutting their losses, will lead to spectacular dollar comeback.

The day before

Tomorrow everything will become clear, or at least sort of clear. At 8:30 AM the U.S. Bureau of Economic Analysis will announce by how much the economy grew the last quoter. The consensus number is 3.1%, the fastest growth since the beginning of the financial crisis two years ago. And there are reasons to be optimistic. All the government stimulus measures should have had their effect by now. However, the problem with stimulus packages is that they are like antibiotics---you need to take them punctually, hope that your bacteria is not drug resistant, and be careful not to damage your kidneys when they circulate out of your system. To translate this, the government needs to continue spending, hope that the signs of recovery are not just a temporary reprieve, and hope that all this spending does not cause hyperinflation in the long run.

In other words, the tomorrow's data may actually perpetuate the uncertainty instead of dispersing it. A simple what if game:
What if the GDP turns short of the expectations?
This will mean that the unemployment has turned from a symptom of the recession into a deceases itself. Really bad scenario, which is not quite impossible--it happened in Britain. There the expected growth was .5%, but it turned out negative, -.4%. Oddly enough, I think that under this scenario the dollar may rise. The invert correlation between bad economic news and the value of the dollar has been one of the particulars of this crisis.

What if the GDP turns much bigger than expected, e.g. 5%? Then the dollar will also rise since this will signify a V-shape recovery, and the market will start prizing an interest rate hike in the near future.

I think that exactly because of this hypothetical developments the dollar is gaining presently. The uncertainty of how the GDP report will shape the market is causing a lot of profit taking. After tomorrow, however, given no surprise, the dollar can promptly go back to the 1.50 level. Lets wait and see.

Roubini agrees with Baronov

In case, you don't remember, in my entry from Sep. 17, I wrote that whatever carry-trade is going with the dollar, there will be a point in the future, when course is reversed and the dollar wins back due to the influx of repayments. Here is what Roubini said:
First,

Now we are in the mother of all carry trades,

and then added

[T]he dollar cannot keep falling forever, and there could be "a market crash all over the world" when the currency's course is reversed.

Does this guy read my blog?

1 1 1

This is just a small observation. As the dollar is loosing value three different currency pairs are gradually moving to parity---the AUDUSD, USDCAD, and USDCHF.

The closest one is the Frank. It closed at 1.008 this week, just shy from the parity mark.

Then there are the commodity currencies, that have been riding the recovery wave as a couple of easy going surfer dudes. The Aussie and the loonie are trading respectively at 1/0.922 and and 1.052 to the greenback, nearing this point where all the dollars in the world will come together as equal and throw a big party to celebrate their colonial heritage.

It seems that these three 1s will be reached at the same time, so when this happens, close your eyes and make a wish. What happens next, however, is anybody's guess. All this talk of how the cheap dollar is hurting the economies of all other countries but the US whispers of a big massive coordinated intervention. It will be a game of chicken, and is there a bigger chicken then the ECB?

And to avoid making my case for ECB intervention, I am just posting a link to an FT article that does it for me.

Gambling and currencies--Las Vegas edition

Folks, first excuse me for not updating your favorite blog for so long. First, I was writing a really boring article for an engineering journal, and then I was enjoying a crazy four-day Vegas vacation, and in between these two things I left my blog neglected. Now, however, your faithful blogger has acquired such indispensable knowledge, as how long can you survive on four hours of sleep a day, should you split two 8ths, and can you call it an after party if it is before 4 AM. (In case you are wondering, the answer to the first question is--a lot if you have pure oxygen inserted in your air circulation system; also, yes you should split the 8ths; and to the last one--people do it only in Boston.)

In Vegas, I also figured out that the great trick of gambling is the illusion it gives of pattern and balance. It was so funny to stand next to a roulette table and see all the suckers that have notebooks (helpfully provided by the casino) for recording the numbers that are showing up.

It is so natural that the human brain detests randomness. The ability to see the structure, and the interconnectedness of the surrounding world is what can help you hunt your prey in the jungle, or conquer your enemies, in the battle field. In the casino, however, it turns you into an audacious spender fixated on a never coming payout.

How this doomed search for pattern is different from technical analysis? After all, from my perspective as an engineer, the rational behind most of the technical analysis tools is as laughable as the logic of the guys filling their notebooks with numbers at the roulette table. Well, there is one major difference between gambling and trading, and this is that in gambling, the house is always pattern-blind. That is, the house is a player that does not believe in anything but the law of large numbers, a player that always wins. In markets, however, there is no such agent. There is a democracy there, and the more players believe in the "pattern", the more it turns into a pattern. Is this, however, more rational than a guy putting numbers in a notebook...

YENbublicous

Have you ever randomly encountered an old girlfriend at some party? You start talking and a guy comes by. She introduces him as her fiancee. You look at him, he is older and uglier: and you want to ask only one question---"Really, that guy?!!". If I was the US dollar this is how I would feel about the Japanese Yen. It looks like the investors are in love with a currency that is as unsexy as a currency can be. And not only is it gaining against the dollar, in the last week it has also gained against the EUR. I will be looking for a rational explanation this week, but I doubt it can be found in the fundamentals. This makes me think that there is a Yen bubble building up, that can easily burst very soon.

There are two questions that I am looking forward to be answered this week and both of them are related to the US dollar.

1. Will the dollar keep losing ground?
2. What will the FOMC statement say?

Since the beginning of September the dollar's decline has been as smooth as a bunny slope ski ride. At the end of last week, however, it seemed that this ride is coming to an end. After storming the 1.475 level the dollar kept flirting with the 1.47 line for the whole Friday. It is quite possible that the current trend is out of steam, at least until the FOMC comes with their view of what comes next. There are two outcomes that are almost sure to emerge from the Fed meeting. First, the interest rate will remain unchanged since inflation is obviously too tame to cause any policy change. Second, it looks like the quantitative easing has run its course and the Fed should be back to business as usual. The FOMC statement should answer, however, the important question of what are the inflation expectations moving forward, and how the Fed plans to answer any changes in the current status in the future. Trichet already had his say on the topic:

Available indicators of inflation expectations over the medium to longer term remain firmly anchored in line with the Governing Council’s aim of keeping inflation rates below, but close to, 2% over the medium term. The outcome of the monetary analysis confirms the assessment of low inflationary pressure over the medium term, as money and credit expansion continues to decelerate.

Now, its time to see what is the US view on the subject, but most probably it will be on the same note. In this line, I expect the EURUSD to remain in the 1.465-1.475 range until Wednesday, when the Fed position becomes clear. Bearing any unexpected developments, the dollar then may continue to lose value, where my personal opinion is that it can cross 1.485 to the end of the week.

The dollar as a carry-trade currency

There are a lot of speculations lately that the dollar is increasingly becoming the top choice for a carry-trade currency. Financial Times writes:

Analysts say negligible US interest rates, its quantitative easing measures and little sign that the country is set to withdraw from its ultra-loose monetary policy anytime soon leaves it in a similar position to Japan at the start of the decade.

Or in other words, the investors find it advantageous to borrow dollars and invest them in high-yield currencies, in the same way they were doing with the Yen until the carry trade burst in the end of 2007. The FT article proceeds at giving equivocal evidence that the current decline of the dollar is caused by the dusting-off of the old vanilla borrow-exchange-deposit strategy, that was quite profitable before the current great recession. Their list is:

1. The dollar LIBOR is currently smaller than the Yens.
   
2. The dollar seems to be losing uniformly against all major traded currencies.
   

I have to agree. To these evidences, I can add the TIC long-term purchases which turned out well below estimates ($15.3B actual vs $65.0B expected). However, my opinion is that the dollar makes a pretty crappy carry-trade funding currency and these are the reasons.

1. The US has enormous current account deficit.
Economics 101 is that a country with a current account deficit is a net borrower. That is it imports more than it exports, and therefore needs somebody (read China) to finance this imbalance. The carry-trade will exacerbate this, i.e. people will be less likely to hold US debt, since they will want to get US loans. In the case of yen as a carry-trade funding currency, this wasn't an issue, since Japan is a net lender, and the carry trade was beneficial for its economy. Joe gives one dollar to Toyota, Toyota turns it into Yens, then Patric borrows it from Toyota turns it into Iceland crones, puts it in the bank and collects interest. Of course, this didn't turn out good for everybody.

2. Inflation is lurking around the corner.
You don't need much for inflation to catch you with your pants down. A sudden spike in commodity prices will be promptly distributed down the chain to both consumers and manufacturers, and bring high interest rates without having stable economic rebound. We've seen that the $150 oil is possible, and there are a lot of scenarios under which it can happen again (think about Iran.) If/when this happens the carry-trade game can easily turn into a game of musical chairs.

To summarize, I am suspicious about the current depreciation of the dollar. There may be a point in the future, that the dollar wins back in a matter of days what the euro has won in the last few months. I'll be looking for the signs ready to catch this fast train back south.

Commodities and currencies

I've always wandered what does it mean to be a commodity currency. It's obvious that there are countries, whose fortune depends enormously on the prices of raw materials, but the question that lingered in my mind was can you play the commodity game purely with currencies, without using any actual futures or commodity ETFs. After doing some late night research, and some Matlab based simulation my question was answered--yes you can do it, fairly easily. I note that what follows does not account for interest rates, but regardless they constitute a nice observation.

I took the currencies of three countries which have economies heavily dependent on commodities, Australia, Canada and Russia. I know that Russia has a funny currency that is controlled (or at least tried to be controlled) by its central bank, but its place is definitely in the commodity basket. I designed a simple index, which in brief consists of a weighted sum of the return of all of these three currencies for the given period--Jan, 2007 to present. Then I assumed an ETF whose performance is the triply leveraged index return.

For comparison I used the GSP ETF based on the Goldman Sax Commodity Index, and here is the result:
To me it seems pretty good. Note that for this period you would have had positive rollover rates for the currency portfolio, therefore my guess is that the adjustment will further converge these two curves.

The week ahead

I woke up this morning and I saw this article in Bloomberg: Goldman’s O’Neill Sees ‘Silly September’ as Yen Appreciates. And this is what I have been thinking all along. Why is the Yen appreciating against the dollar. It has a shaky export oriented economy, a history of economic mismanagement, and really low yielding bonds. Who really things that this can be a good investment. First, the yen appreciation was explained by the flight from risk, but what about now that the conventional wisdom shows that the global economy is on recovery mode. The clumsy Japanese currency is definitely not the way to profit from this. Add to the mix the fact that its export can be slowed by this high exchange rate, and that the Japanese central bank has a history of intervention, and it seems for the Yen it will be all downhill from here.


The euro vs. the dollar, seems to me more like a mind reading game then anything determined by fundamentals. If you ask me Europe is far away from being out of the woods. The European countries are in unfamiliar ground--when was the last time Germany was running a deficit. However, the Euro can continue to appreciate. It tried storming the 1.46 bound, it passed then it retreated, but you can still see that somebody's still pushing. This however will continue to the point where somebody figures out the inflation game---where will it start and who will be first to raise its interest rates.

The babylon paradigm

Why the Babylon paradigm?

When I think of the Babylon tower I think about the great schism of the human kind. The last common endeavor, the ultimate challenge to reach God that ended in ruins. It is the perfect metaphor of our civilization's dysfunction---a common ground beneath us, but yet so many languages to convey this.

Lost in translation are feelings, ideas, and ideals. And this is how humans describe their thoughts, but what about the way they describe their wealth. One dollar to the western men means a colored, high-fructose corn syrup sweetened beverage. For a Somalian family, it means meat for dinner this month. This same dollar can buy me 1.4 levs in my home, Bulgaria, with which I can sit in the pub and enjoy a cold beer. In other words, to translate one's wealth to another human being is as difficult as to translate one's thoughts. The question then is what destroyed the Babylon tower. Was it the inability to tell the fellow mason how to put one more stone in the tower, or how to measure the value of his work against yours. Did God destroyed our effort to reach him through giving us different words, or by giving us different ways to define our fortunes.

Thus, for me the foreign exchange, the translation of the wealth of one nation into the wealth of another, is a remnant of this Babylon legend. Now that the new tower called globalization is being build, how the human race is exchanging its currencies can determine the fate of this new endeavor. The volume of this exchange is tremendous, every half a month or so, through the Forex market passes the equivalence of the world yearly output (World GDP 2008= $60 tr., Forex dailly turnover> $4 tr ). Observing the trends that emerge through this process is like observing the twists of history---from close it can look as random as the bouncing of a single atom, but from afar everything looks as natural and predetermined as the flow of the Mississippi river.

This blog is my take on the foreign exchange market. I will try to share my thoughts of the immediate randomness that rocks this world, and try to put everything into the context of the big currents of wealth translation.