Thursday, June 27, 2013

A Primer For Interpreting Random Market Profiles And Reactions To Economic Data

This a fairly broad topic, and any "rules" would be vague at best, so i'll use recent trading activity as an example.

First - the background:  The UST market has just exited a supply-imbalance.  "What is a supply imbalance" you ask?   A supply-imbalance is simply a state of the market where the markets general mean reverting force has become overwhelmed by a large broad based position, that was not wanted or intended by one side.  Imagine being given a long position in 50bln 10yr notes..and thinking "i don't want this."  You didn't go out seeking this position...but you are a market maker and 50 guys all said bid 1000mm (thats 1bln) 10yr notes...and violla..there you are (perhaps they hit you elctronically and you auto quoted...perhaps you just weren't paying attention to the accumulation in your book...perhapos "you" are the aggregation of all 20 primary dealers....the how is unimportant...the position is important).  You now have a position..and you want out.  You are afraid to sell into the market, because your initial small sale will most likely push the mkt against your remaining position.  So what do you do?  You sell some and you offer..that's what you do.  You offer and if the mkt ticks offer lower.  You keep doing this until your position is gone.  Unfortunately...during a are not alone...all the other market makers are in the exact same position...which is why the mkt seems to just melt when there is a supply-imbalance. you keep selling away your position (at this point the mkt has moved quite a bit against your position and your P&L is down millions) the original large seller who gave you the position will re-enter the market and say "i'll buy it all."  Of course they do this as sneaky at possible...they become the bid in the market, and perhaps they buy from the dealers thru proxies thus hiding their identity.  At this point, the original liquidity providers are just glad to exit their position without losing any more money.  At this point, lots of guys are worried about getting fired..going bankrupt..all sorts of fear is rampant for those on the wrong side.  The basic human psychology of FEAR is responsible for this behavior.  In this case...the FEAR of losing it all.  This fear is exactly what allows the original large seller to cover his position.  Now imagine this game repeated over and over and over again.  Clearly, being the large trader who can initiate this process is like a license to print money.  If you know the depth of liquidity of a market...then you can trade large enough to overcome that liquidity (one might even go so far as to say you are able to manipulate that market).  This is the trader that i follow at GovtTrader - he is our bread and butter.

Back to our original the supply-imbalance was created (big concentrated seller)...the market distributed (mkt sells off in price - a lot)...and then the supply-imbalance was alleviated (the big seller covers).  What happens next?  Well, the mkt has moved due to the trading activity we just discussed (in this case...4 points down..followed by almost 2 points up off the net/net down 2ponts (64 ticks) from where the original trade began)...and the mkt may or may not fully return to where the initial large traded started the whole thing in the first place.  Howerver...somewhere in the middle is where we expect the mkt to find stabilization.

That's where the UST market is the stabilization process post supply-imbalance alleviation.  The stabilization process is much harder to predict with accuracy than the supply imbalance induced supply distribution...because....well...the market's net position has returned to "balanced."  Balanced markets tend to behave randomly.  In the absence of anything else would expect the mkt to randomly drift back to the point from where our story started (129-00).  Balanced markets that have not been distorted due to supply imbalances tend to have a nice mean reverting shape.  But of course...we never have an "absence"...there is always something going on in the world..or somebody important talking about what they think might happen in the future...or some new economic data.  So, we start the day (like today) random with a potential skew up....the mkt shows us its initial balance (today 126-12)...or point of control...or the "mode" as we call it.  And the mode tends to control the market...until something else happens...and something else always happens.  That is why trading for mean reversion to the mode is something to trade for in the morning.  By the afternoon...there is new information...and the market will absorb all that new info (including trading activity) and gravitate to a new mode.  The new mode (this is the statistical term) might not be apparent until the afternoon or the following day.  This is yet another reason why we prefer to trade in the morning.

So, again back to our original question - how to trade a random market, and lets add "in the morning."  Since mkts move via trading activity...we expect the mkt to move away from the mode.  So long as the trading activity is not concentrated and 1-directional...we can expect that activity to gyrate the mkt away from and then back to the mode.  Sometimes we only get 1 chance to capture this...sometimes we get 3-4 (today we had 2-3...the 10am data...and the chop between 10:30am --> 12 noon).  To be time wears on...the probability of playing for a return to the mode diminishes...which is why the first trade in this model (in the morning) is usually the best trade.

Lets zoom-in on todays price action....

The market tends to react to economic data in a schizophrenic manner.  For example...the 10am PendingHomeSales data was strong (good for the economy...bad for bonds)...and yet..the mkt traded higher.  Dudley comments hit the wires talking about QE..but those comments were also bad for bonds.  When we step back and think about the PendingHomeSales..we realize that those data points came from before this recent rates in actuality not really helpful.  However, the mkts initial reaction to this data (via an algo)...take bonds (ZN) higher by 6 ticks (from 126-19 --> 126-25) which seems to hit a few stops (pre-10am we calculated 126-22 as the top of the bell curve on twitter)....followed by a slam back to the mode @ 126-12 (also described on twitter).  The market gyrated around the 126-12 mode (+/- 3 ticks) for the next 2 hours.   According to our "rules"...that's was time to stop trading.

The 1pm 7yr auction gave us a new piece of information...there was strong demand for paper.  Perhaps the bias for the mkt to return to the pre-supply imbalance price is stronger than we thought...that is certainly a possibility.  Then again...if the Fed actually does reduce QE (and communicate this)....should we expect a massive selloff?  Might that change the demand picture?  Is the current demand picture just a "front-run" of tomorrow's month-end buying?

Too many questions without clear answers.  So, i'll wait for tomorrow morning to show me if there is a clear mode that i can trade around.  Without a supply-imbalance to guide us...any decent sized flow can dominate the market.  This is the type of market where traders become economists...the mkt is slow, allowing us time to think.  Slow does not necessarily = easy.

So, we think the market is random...we know there is some bias to return to the price from whence we came, but we don't know how strong that bias is...and we have a scattering of economic and auction data (and FedSpeak) to help us try and understand what the market wants to do next.

So what do we know....
-We know the Fed doesn't like having such a large balance sheet.
-We also know that they like high un(and under)-employment even less. 
-We know that QE doesn't directly create jobs (the transmision mechanism is indirect at best...low-cost govt debt allows congress to spend more and inflated asset prices create a wealth effect which stimulates spending...and that creates some jobs...but the Fed would be much more effective if they just hired 8mm people for 50k/year). Cost 400bln / year.  This would be much more stimulative...and also much more inflationary...and the Fed can't do this.
-We know that banks aren't lending more money just because the Fed is doing QE (and bank-lending has been the source of most growth in the past)

-We don't know if the economy is growing fast enough to engineer a recovery.  My best guess is that the real economy is stagnant (unemployment claims and job growth seem to be net/net a wash).  Arguments can be made to slightly either side of that point...but nobody can say with a straight face that the economy is heating up such that the Fed needs to put on the breaks.

So...from the economist standpoint...there is no equivalent to a supply-imbalance that can predict what tomorrow will bring to the markets.  So was my economics degree a waste of time and money?  I now know that i don't know whats going to happen least i'm not ignorant of my ignorance...

We know tomorrow is month / there will be some month-end buying...but we don't know if the peak will be in the morning...or in the afternoon (the stats are split 50/50 on this).  After month-end buying is done...what else do we have?  3 Fed speakers tomorrow should create some volatility and give us a little more info.  In 2 weeks we have the next round of long-end (10yr and 30yr) supply.  We will surely have more FedSpeak (and jobs data) before we know there is volatility in our future.

In other words...we don't know very much.

Sure..if PIMCO decided to go surprise buy 200bln 10yr notes tomorrow...that would move the mkt and be a high probability trade to ride along with....but they are not going to do that's out the window (and if they are...they aren't telling).  Either waiting for a supply-imbalance that we can read (2-3 times per month)...or waiting for a morning mode-reversion trade, is the safest (statistically) trade to make...and so that's what i'll do..because i'm not a gambler...i'm a trader....i can afford to sit on my hands and do nothing when i don't have a clear advantage. 

You never know when the clear advantage will show up...and that's why we sit and stare at the market all when the opportunity presents itself...we will be prepared to strike.

There are probably a bunch of people out there who think traders like me are wasting our lives (essentially playing crowd-sourced video games revolving around money for a living)...and to an extent...they are absolutely correct....but no other job pays as either give me a better alternative...or let me make my money trading.

1 comment:

  1. Sir,

    What is your view on the bond mkt being driven by the unwinding of levered carry trades predicated on -ve US interest rates & more importantly, on a time frame of 2014 rather than 2013, for which bonds were financing collateral ?