Testing Tuesdays

Wednesday, April 23, 2014

Bob Geldof famously doesn't like Mondays, a sentiment which is likely shared amongst wide swathes of the population.    He presumably has no beef with Tuesdays, and if the populace at large is fairly neutral on the second day of the workweek, the same can probably not be said for equity punters.  For as Citi's Brent Donnelly pointed out yesterday, the stock market's performance on Tuesday has been nothing short of spectacular.

Perhaps it's mere coincidence or a statistical quirk.   Maybe it's the sign of dark forces at work.  Frankly, Macro Man doesn't know.  All he can say is that thus far in 2014, the SPX has rallied an impressive 8.75% on Tuesdays....and dropped a cumulative 6% on the other four days of the week.

Now, when Macro Man was reminded of this phenomenon, he thought it sounded a little familiar, so he did a little digging.  Sure enough, just last year, the cumulative week 17 performance on Tuesdays was 7.89% versus just 2.71% for the other four days.  In fact, the SPX started the year by rallying on 19 of the first 22 Tuesdays, a not dissimilar hit rate to 2014's 15 out of 17.  So what happened next?

To a large extent, the outperformance evened out.   Indeed, from week 22 onwards, the SPX was down nearly a percent on Tuesdays, versus a cumulative rally of nearly 13% on other days.  While the index still punched above its weight for the year as a whole, the discrepancy wasn't nearly as notable as it is today (or indeed was a year ago.)  If anyone has a rational explanation for why Tuesdays have been so great for the first 4-5 months over the last couple of years, Macro Man would love to hear it.   Failing that, he'd suggest that anyone betting on a sustained continuation of this outperformance trend might find themselves tweaking the Boomntown Rats song before too long.

Elsewhere, sterling has been rather notable for its strength in recent days, with cable pushing to its highest level since 2009.  To be sure, some of this strength reflects the relative resilience of the UK data, which itself has filtered through into rate markets.  Nevertheless, it does look like sterling might be a little ahead of itself, even if one accepts that current rate differentials are justified.

That in and of itself is an open question.   While economic activity is clearly quite brisk (and house prices in the Southeast downright rampant), CPI inflation is at its lowest level in 5 years.   Given that Woodfordite central banks pursue a function wherein Policy target = min( employment, CPI, GDP), this should provide ample opportunity for Mark Carney to contrive excuses to keep policy unchanged, perhaps up until the election.

Indeed, Macro Man's own work suggests that appropriate rates based on the post-crisis, pre-Carney reaction function of the BOE are already quite a bit lower than they were a few months ago given the drop in inflation.  As such, it would appear that the in the near term at least, the prospect of UK rate rises might be close to fully priced...

Moreover, the Scottish referendum is now less than six months away, and the polls seem to be swinging ever closer to a dead heat.  History suggests that constitutional referenda  tend to exact an ex ante risk premium in currency markets (viz. the euro in 2005 and the CAD in 1995) which at the moment is absent from sterling.  As such, from Macro Man's perch, sterling should carry a large 'caveat emptor' sign at current levels.

Finally, it will be interesting to see if UKIP follows through on its plans to make the newly-available David Moyes its Head of Strategy.   After all, if he can keep Manchester United out of Europe.....

Posted by Macro Man at 7:00 AM 7 comments Links to this post  

A Market Vignette

Tuesday, April 22, 2014

In the absence of anything interesting to say about a drearily dull start to the week, Macro Man thought he would share a small vignette of what the market was like two decades ago.

Macro Man's very first job upon graduation from university was in Chicago, working for a very well-known option market-making firm.  Having acquired an interest in foreign exchange while studying abroad during the '92 ERM crisis, he was assigned to work at the currency options pit of the Chicago Mercantile Exchange as a trading assistant.

Before arriving in Chicago in July of 1993, he wasn't really sure what to expect.  Having attended a liberal arts university, he had taken no finance courses; as such, the only options knowledge he possessed was what he'd crammed for the interview to get the job in the first place.

From what he could tell, however, it was pretty complicated stuff.  The firm he was joining had a reputation for being staffed with really smart people (naturally- they'd hired Macro Man!), so he assumed that the business generally was populated by the types of guys who broke the bell curve in collegiate math courses.  After all, the chaps on TV who talked about the stock market all sounded pretty clever, and anyone who'd read Liars Poker knew that they were bottom of the intellectual heap, right?

The job, as it was explained to Macro Man during the offer, was to assist the firm's option traders in the CME pits while slowly acquiring sufficient practical and classroom knowledge to eventually become a trader himself.  All in all, it promised to be intellectually stimulating while serving up the odd jolt of adrenaline when things got a little crazy.

Upon starting the job, your author found that (unsurprisingly, in retrospect) the quotidian aspects of the job were somewhat more mundane than anticipated.  Perhaps he should have been warned when he found that all the traders referred to his yellow-coated brethren as mere "clerks" rather than the more elevated "trading assistants," though given that most of his early-career tasks were indeed clerical, the shoe fit (and he wore it.)

What was really shocking, however, is when he actually went to the exchange floor to work during trading hours.  The roar of the floor, particularly during a data release, was startling but hardly surprising.   No,what really opened his eyes was the people.

Contrary to expectation, the floor was not primarily populated calculus curve-breakers.   Oh sure, some of the options guys were really smart, both in an academic and street sense.  The futures traders and brokers, on the other hand, while hard workers and good at their jobs, were more notable for the size of their beer guts than their IQs.   These were salt-of-the-earth guys, many of whom might be digging ditches if they weren't on the floor.

There is perhaps no other job in the world where flatulence is as much of an asset as it is on an exchange floor.  Have you been squeezed out of a good location in the pit?  Drop a little "bomb" and the crowd will part like the Red Sea, allowing you to occupy your preferred spot.  Certain traders developed a knack for letting fly right before a large order came into the pit, thus ensuring that they could occupy the prime real estate in front of the broker and do a large portion of the trade.

In  Macro Man's second week of work, the senior trader he was clerking for got into a fistfight with a rival trader.   This was not a typical baseball fight with lots of milling around and little actual violence; this was a proper punch up.   Macro Man happened to be on the edge of the pit to pick up some trading cards from said trader (nicknamed 'Johnny Ya-ya') and saw the whole thing unfold before him.   He instinctively grabbed Ya-ya's opponent but was ordered instantly to let him go and leave the pit.

After the fracas broke up, Ya-ya stormed off of the trading floor.   With one brief exception a few months later, he never returned, having transitioned to an "upstairs" job trading OTC options.

One aspect of the floor that Macro Man remembers fondly was the prevalence of ridiculous bets.   Traders, clerks, and  brokers would have a flutter on everything, from the first day of snow (it was Halloween 1993, if memory serves) to the height of the trading floor (architectural plans were consulted) to who would win a fight between a killer whale and a great white shark (Macro Man rang the Chicago aquarium to get an expert answer on this one, perhaps inspiring this show.)

There were three bets, however, that still resonate with your author to this day.   The superstitious might even suggest that they offered foreshadowing of the financial crisis and its aftermath.

A foot of cockroaches.   There was a broker in the Deutsche mark option pit called Chris who was a bit different from a lot of the guys- he seemed older and he wore a pony tail, which wasn't a common barnet on the CME in the early 90's.  Oh, and he claimed he could eat a foot of cockroaches (i.e., twelve inches' worth of cockroaches laid end to end.)

Naturally, this inspired a modicum of skepticism from other denizens of the DEM pit, so a few friendly wagers were offered...and then a few more....and a few more.  Brokers bet with brokers, traders with traders, clerks with clerks.  Eventually, after work one day, the cockroaches were somehow procured, laid end to end.....and duly consumed.  Bettors on Chris were paid out, and Macro Man learned very early on that not only is there never only one cockroach, but that even the most foul of (financial) fare will usually find a consumer.

The NCAA tournament.  Betting on the NCAA college basketball tournament was rife, unsurprisingly.   Unlike the relative tedium of filling in brackets and tracking overall accuracy, NCAA betting CME-style was devastatingly simple.    The winner of the tourney was worth $100; everyone else was worth nothing.  Markets were made in each of the teams, and you were obligated to keep track of which teams you bought and sold, in which quantity, with whom, on the free trading cards that that were a staple of the CME.

This was all well and good, provided that one sized their positions correctly and managed risk.   In many ways, this sort of trading taught neophytes like your author as much about risk management as his professional activities, given that it was our own wealth on the line.  Unfortunately, not everyone learned his lesson.   A clerk for a rival trading company owned by a French bank fared rather poorly, losing some $15,000 in the process to all manner of floor personnel.  (Remember, this was more than two decades ago, so the sum was almost certainly in excess of half of his annual salary.)

This proved to be quite a thorny problem, as the kid couldn't pay, which irritated his creditors rather considerably.   Eventually, a compromise of sorts was reached:  the clerk was sacked and the bank made good on his debts to avoid the stigma of having stitched up the rest of the floor.   This was quite an early indoctrination into the concept of "if you lose enough money, eventually somebody will bail you out for 'the common good.'"

Fifty Reese's Cups.    On the wall of the exchange, surrounding every pit, there were rows of little boxes with phone turrets where clerks would accept orders from "upstairs" and signal them into the pit.   There was a guy who assisted one of these phone clerks who was big.  Not Big Ten football lineman big, Augustus Gloop big.   As memory serves, he took a bit of ribbing about his size, but was generally good-natured about it.

Somehow, one day the phone guys started talking about Reese's peanut butter cups, and how many one could eat at a single sitting.   One thing led to another, and the gauntlet was thrown down as to whether Augustus could eat 50 Reese's cups.   Call it a financial version of Cool Hand Luke.

As in the film, the entire proposition inspired a raft of betting, except in hundreds and thousands rather than twos and tens.   Consensus was probably tilted very slightly in Augustus's favour until someone thought to ask him if he liked Reese's cups.   "They're my favourite," he replied with a glint in his eye, thereby spurring a frenzy of betting on "Yes."

As with the cockroaches, the Reese's Bacchanalia was scheduled for after the close on some appointed day.   In the run-up to the eat-a-thon market anticipation built to a fever pitch, and even those benighted souls with nothing riding on it were eager to see if Augustus could emulate Paul Newman.

Alas, it was not to be.  On the morning of the appointed day, the news rippled through the trading floor: the bet was off.   Apparently Augustus, in a rare fit of concern over the state of his well-being, had taken the outlandish step of consulting a physician about the proceedings.   This worthy individual had warned him of the potentially disastrous consequences of scarfing that much candy in one sitting (presumably hyperglycemia.) 

The moral of the story, of course, is that it is possible to have too much of a good thing, even a favourite sweet.   Readers will no doubt have deduced by now where Macro Man stands on this issue vis-a-vis the raft of easing measures served up by Willy Wonka the Fed and BOE, among others.

'Tis a pity that the professors who run monetary policy these days never spent any time on the Merc floor.   Perhaps Chris, the wayward clerk, and Augustus could have taught them a thing or two...

Posted by Macro Man at 7:00 AM 7 comments Links to this post  


Monday, April 21, 2014

The past week has been notable for the victory laps taken by central banks currently residing under the thumb of Professor Moriarty Woodford.  In last week's speech to the Economic Club of New York, Janet Yellen noted that forecasts for unemployment were largely proven correct- but only with a healthy dose of QE to grease the wheels.   Latterly, Martin Weale at the Bank of England has performed an exhaustive study suggesting that QE worked even better than originally thought.

All of this is well and good, and the Weale paper is full of Bayesian vector autoregressive fun, if you're into that sort of thing.  The problem with these sentiments, of course, is that they are based in one way or another on the very types of econometric models that have failed so spectacularly over the past seven years.   The counterfactual ("what would have happened if there were no QE over the last few years?") is easily dismissed, because it is unprovable.

Perhaps Macro Man is the only one irritated by this casual dismissal of the counterfactual.  After all, irritation is not a particularly remunerative emotion, and what's done is done.  Nevertheless, it is perhaps worth pointing out a few holes in the logic.

In Yellen's speech, she noted that the unemployment came in just about where it had been forecast, but only with the aid of QE.  Observe how she was careful to use private sector forecasts rather than the Fed's own estimates.   Macro Man ran a little study, comparing the unemployment rate from 2012 onwards with where the Fed itself had forecast it 12 months earlier.  As it turns out, unsurprisingly, the unemployment rate has been consistently lower than the Fed had forecast 12 months earlier- by an average margin of 0.4%.

So in point of fact, if QE had an impact, perhaps the Fed didn't need to do it after all, as their unemployment rate forecasts might have been more accurate!

Of course, the real question for Ms. Yellen is "if QE was so great at keeping the unemployment rate below your forecast, why was it so lousy at keeping economic growth at your forecast, let alone above it?"

Were one to actually pose such a question to the Fed, the response would no doubt be full of phrases like "fiscal drag" and "participation rate" and "part time employment" and stuff like that.  (It would be churlish to ask why the econometric models did not forecast this stuff, too.)

Of course, with fiscal policy, there is another unprovable counterfactual that is blithely waved away.  The Fed's attitude towards the government has been one of an overindulgent parent towards a squalling infant or squabbling toddlers, the type that always seem to sit in close proximity to your author on airplanes.  Rather than using the stick of "shape up or else", the parent/Fed adopted the carrot strategy of "here's a little sweetie to keep you quiet for five minutes."  Of course, the lesson learned by the naughty children is that having a fit brings a reward....so it encourages more fits.  (The same holds true for the infants in the airplane example.)  For all his many faults, it's hard to imagine that Alan Greenspan in his pomp wouldn't have let off a few rockets in his Congressional testimonies to put an end to some of the nonsense.

Just once, it would be nice to see a headline that differs from the usual


Instead, it would be great to see something like


Sadly, that's one for the alternative universe newswire (or maybe a couple of the regional Fed presidents.)  It's too bad, really....that's a counterfactual that Macro Man could really get behind.

Posted by Macro Man at 7:00 AM 9 comments Links to this post  

Go on, you know you want to

Thursday, April 17, 2014

"Go on, you know you want to."

How many times over the last few years have macro punters contemplating a sale of the euro heard that voice inside their heads?  From the sovereign crisis to Cyprus, from Fed tapering to ECB QE,  there have been a myriad of (apparently very good) reasons to sell EUR/USD, and yet here we are, knocking on the door of 1.40.  Like the devil on Larry Kroger's shoulder, the voice looks at the chart and says it again.

"Go on, you know you want to."

It's a siren song that's hard to resist, particularly now that the ECB has joined the chorus.  In the absence of a ship-mast against which to lash themselves, punters would do well to examine some of the relevant narratives to determine whether it's a wise course to give in.

1) The 'Japanification' story.   A key argument against selling the euro has been the impressive rise in the Eurozone's basic balance over the last several years.    Not only has the emasculation of domestic demand in much of Europe pushed the current account into a tasty surplus, but Eurozone banks' unwinding of foreign assets has maintained a healthy capital inflow as well.  This combined demand for euros has gotta push it up, right?

The evidence is sketchy.   Macro Man can find no stable and sustained relationship between the basic balance and the euro.  That does not mean that there is no relationship, of course, merely that it does not appear to be a (let alone the) hegemonic driver of the euro exchange rate.  Indeed, at some points in recent history there appears to have been a negative correlation between the two.   The voice is getting louder....

2) Positioning.  With so many different actors participating in currency markets, it can be quit difficult to get a true read on accurate positioning.  Fortunately, the sector with the quickest trigger finger also happens to be the easiest to model positioning for, namely CTAs via the IMM data.  The story there is one of modest (and declining) length.   With the 50 and 100 day moving averages 50-120 pips lower from current spot, it wouldn't take much to trigger a flurry of stops, as that community exits longs and begins to go short.   The siren's song, it's so beautiful....

3) FX Reserve managers.  One of the earliest literary devices in this history of this space was the bequeathing of the sobriquet "Voldemort" upon the PBOC and SAFE.  The rationale was simple:  by accruing absurd levels of FX reserves to maintain artificially weak exchange rates (and artificially high current account surpluses), and then trading/investing these reserves aggressively, Voldemort and like-minded institutions were exerting a malevolent influence upon developed financial markets. Over the ensuing years, the influence of FX reserve managers has waxed and waned.  Recently, China appears to have been at least moderately active diversifying the $100 bio+ that they spent in Q1 to weaken the RMB.

However, how durable is this moving forwards?  The stated purpose of widening the RMB band and pushing the currency weaker was to discourage hot money speculation (both domestic and foreign.)   For the time being, at least, it certainly seems to have worked; moreover, it seems unlikely that the domestic corporate sector will play as many over-invoicing games as they have in the recent past.  At the same time, China's current account balance has shrunk back the level (as a % of GDP at least) of a dozen years ago, back when Voldemort was a mere Tom Riddle...

It therefore seems likely that reserve accumulation should slow, perhaps dramatically...and with less reserve accumulation comes less diversification demand for euros.   Hmmm, Macro Man is reaching for his red sell tickets....

4)   Interest rates.  Rate differentials are the bread and butter of any study of exchange rate determination.  Applying them to EUR/USD appears to support the conclusions above.   Based on the historical relationship with the 1y1y spread, for example, it looks like the euro should be closer to 1.20 than 1.40.   It's an open and shut case, right?

Not so fast.  Readers may recall that there were other interest rates than 1y1y swap spreads (themselves a proxy for monetary policy) that were driving the euro exchange rate in 2011 and 2012.   A proper rate model should include some sovereign spread component.   Macro Man ran two iterations of a very simple two factor model, using a measure of short term rate differentials and the 5 year Spain/Germany spread as the input factors.  One uses 2010-11 as the in-sample period (the Trichet model), and the other uses 2011-2014 as the in-sample period (the Draghi model.)

The Trichet model is not dissimilar to something that Macro Man ran in real time in 2011.   What's interesting to note is that the model broke lower relative to the actual market starting in July 2011- almost exactly the time that Italy and Spain got properly sucked into the sovereign crisis.  While the model has consistently suggested that the euro is too high since, it has retained a reasonable degree of correlation with movements in the FX rate, even in the out of sample period.   What is very interesting to note is the seemingly inexorable rise in the model since Draghi's "whatever it takes" speech in the summer of 2012.  How does it look if we use Draghi as the in-sample?


Pretty darned good.  Encouragingly, the basic shape of the model barely changes from the earlier version with a completely different in-sample data set. This version merely corrects for the structural break that occurred in July 2011.  The message, as you can see, is that the euro is pretty fairly valued, and that the recent rise is completely justified. 

Now, one can quibble about using a model like this to try to pin-the-tail on an exact currency valuation.  Indeed, Macro Man received a first-hand education on the dangers of such a practice three summers ago.  Nevertheless, to his eye at least these models do a pretty darned good job in explaining the underlying direction of the euro's trend.  And they both agree that it is up.

As such, from his perspective selling euros, while potentially profitable around event risks like ECB meetings, does not carry a terribly large (or even positive) expected value on a more strategic basis.  From his perch, therefore, it appears that punters' time could be more profitably spent finding a better trade.

Go on, you know you want to.

Posted by Macro Man at 7:00 AM 16 comments Links to this post  

Holy Whiplash, Batman!

Wednesday, April 16, 2014

Holmes and Watson have repaired to Baker Street for a well-earned break, leaving Macro Man to confront the rather more prosaic task of making sense of this week's price action.  With school holidays on either side of the Atlantic and Easter coming this weekend, it's probably safe to say that neither staffing levels nor market liquidity are particularly high at the moment.

Even with that qualification, Tuesday's price action was a little crazy.   The data, such as it were, was generally negative for liquidity (and therefore risk assets): a higher CPI and somewhat weaker Empire do not exactly scream "buy stocks!" do they, particularly when equities (and equity managers) have been on the back foot recently.   Yet buy stocks they did, at least until negative headlines about Ukraine hit the tape.

Now, at his old job Macro Man had a large placard taped to one of his monitors, imploring him "DO NOT TRADE ON HEADLINES."  There is a reason for this.    While the unraveling of eastern Ukraine is certainly a serious matter, as indeed is Russian intransigence, in February we learned that if Americans cannot find a place on the map, it doesn't matter.  And so sometime after lunch, the market came to its senses and rallied back through the intra-day highs.

All of this is one explanation for yesterday's price action.

An alternative, possibly more accurate, explanation is that this week is option expiry week, cash equities are closed on (Good) Friday, and there is a pretty decent slug of open interest in the 1825 strike (25,000 calls and 47,000 puts.)   Assuming that dealers are short this stuff, that's a lot of negative gamma to be hedging as Spooz cross the strike over...and over....and over again.   On an exclusive basis, Macro Man has procured some video footage of this hedging activity from yesterday:

Holy whiplash, Batman!

Not that other assets were immune.  Gold took a precipitous drop after breaking the 200 day, stopping just before the lows of early this month, before retracing to end the New York day just north of 1300.  For longs expecting a Ukraine-related boost, it must have felt a bit like hanging out with Kenny Bania.

Media reports suggest that Janet Yellen made a daring escape from Holloway Castle yesterday and has absconded back to the US, where she will today make a speech to the Economic Club of New York.  Time will tell if she is still in the service of the Professor or whether she has made a break from his nefarious schemes.  Going back to the SPX for a moment, one thing that caught Macro Man's eye in yesterday's tumult was the fact that yesterday's price action broke above last week's low, ensuring that the down trade is a 3 wave, corrective affair.  While it certainly doesn't jive with your author's base case view of weakness next month, it would certainly be consistent with the notion that Woodford still has his tentacles wrapped around monetary policy (i.e., a dovish speech tomorrow.)

Elsewhere, New Zealand's CPI printed a lower than expected 1.5% in Q1.  It seems highly dubious that this will dissuade Governor Wheeler from continuing to hike rates, though of course it does raise the odd question or two about the ultimate magnitude of the cycle.   To Macro Man's eye, AUD/NZD looks to have formed rather a nice bottom and has conclusively closed above the 100 day moving average for the first time in a year (when it was at 1.25.)   He will leave it to the reader (with the aid of Holmes, perhaps?) to explain why a level of CPI consistent with a tightening cycle in New Zealand requires angst and hand-wringing in the United States...

Posted by Macro Man at 7:00 AM 7 comments Links to this post  

The Mystery of the Dots, Part II

Tuesday, April 15, 2014

A continuation from Part I

I returned to 221B Baker Street with an FT, an Economist, and a large bag of wine gums.  I recalled that while confronting a particularly vexing problem, Holmes had often taken to chewing the latter between puffs of his pipe.

"Anything else I can do for you, Holmes?" I asked as I handed over the items.

"Be a good chap and get me that copy of Who's Who in Finance, will you?" he replied, pointing his finger to the bookshelf behind me.  I retrieved the slim volume and wordlessly handed it over to him.  He placed it on the desk, then immediately bent over the two diagrams that Ms. Yellen had left him, immersing himself in their decryption.

While I struggled with the solution to the Times Su Doku and simple crossword, for the next several hours Holmes remained seated silently at his desk, stirring only to suck on his pipe or pop a wine gum in his mouth.

Finally, at dusk he yawned, stretched his arms to the ceiling, and stood up.   "Watson, we're making progress, my boy!" he said, with the slightest hint of a smile creasing his features.   "Still, there's more to be done. "

"What can I do to assist?"

"Run down to London Library and fetch a copy of the latest IMF World Economic Outlook, the proceedings from the 2003 Brookings Panel on Economic Activity, and every Federal Reserve Open Market Committee statement since February 1994." 

"With pleasure, Holmes."

"Watson, I've missed you, truly I have.   As an assistant and a foil you are peerless.  Oh, and while you're out, drop by the Yard and invite friend Lestrade round for an early lunch tomorrow."

Flushed by the praise from the world's preeminent detective, I caught a hansom cab to the library, where with the help of a consulting librarian I managed to procure the documents that Holmes required.   Carrying them in a large rucksack, I walked through St. James's Park to Scotland Yard.   Lestrade was out arresting a few LIBOR traders, so I left the message from Holmes and caught another cab back to Baker Street.

Holmes was in no mood to dine, and I was in no mood to go hungry, so after handing him the bag of documents  I went to the Royal China Club for a dinner of chili lobster and a rather decent bottle of Nuits-Saint-Georges.  I returned to his chambers to find him in almost a frenzy, a pile of documents strewn over his desk.   He consulted one sheaf of papers, and after making an annotation in a small, leather-bound notebook, tossed it aside to examine another.  It was clear that Holmes would be working for many hours to come, so I left the room as silently as possible, descended the stairs onto Baker Street and made my way back to my own quarters.

The next day dawned unusually warm for an early spring morning, with the sun making its first appearance in the London sky for what seemed like months.  It was therefore a pleasure to walk from my chambers to those of my friend, all the more so because of the sense of anticipation that gripped me.  Although I could not fathom the meaning of those bizarre diagrams, it was a comfort to know that if anyone in the world could unlock their secret, it was Mr. Sherlock Holmes.  

Mrs. Hudson extended her usual welcome when I arrived mid-morning, and allowed me to make my own way up to Holmes's sitting room.    Although it was just past ten, he was finishing up a plate of scrambled eggs and toast, topped up with appreciative sips of a large mug of tea.  Long experience told me that he had not slept; my friend's iron constitution and force of will allowed him to make demands of himself while working on a case that would overwhelm a lesser man.

"Good morning, Watson, a very good morning to you indeed!"  Holmes clapped me on the shoulder as I sat next to him at the table.

"You've found a solution, then, Holmes?  What do those dots signify?"

It was a frequent habit of my friend to wait for a particular moment of his own choosing to divulge the results of his inquiries.  Although he often chided me over the years for my sensational accounts of his adventures, he nevertheless had an uncanny knack for revealing his solutions in a manner that enhanced their dramatic impact.  Today, it appeared, would be no different.

"Now, now Watson!  "'Twould be rude of me to unlock the mystery of the dots before our guests are here, would it not?  Now, please allow me to freshen up before they arrive.   Please, make yourself comfortable, won't you?   No, try the seat by the door, and do keep your service revolver handy if you have brought it with you."

I picked up a copy of the Illustrated London Gazette and perused the sporting pages while Holmes readied himself.   He emerged from his dressing-room at five minutes to eleven, then went to his desk and opened a small dossier of papers as if double checking them.   Apparently satisfied, he closed the folder with a small, satisfied nod and sat upon the settee.   "Well, Watson," he said, rubbing his hands eagerly, "this promises to be very interesting indeed."

At the appointed hour the bell rang, and we could hear Mrs. Hudson usher our client up the stairs.   The door opened, and the elfin Ms. Yellen walked nervously into the room.  As we stood to greet her, Holmes gestured to the seat opposite me, saying, "Please sit, Ms. Yellen.  I believe you prefer the chair?"

"I do, thank you."   She walked over, made herself comfortable, and then looked at Holmes expectantly.   "Well, Mr. Holmes, have you got any answers for me?  Do you know what the dots mean?"

"I do, madam."    Our client exhaled deeply, as if a great weight had been lifted from her shoulders.  'However, before I share the results of my investigations, I must ask you a few questions."

Ms. Yellen nodded her assent.

"Tell me, madam, in your telegram to me you mentioned something about the case being 'vital to the world economy', yet when you were here yesterday there was no explanation of how or why?  Similarly, you referred to a big project that was winding down at your office, but refused to elaborate.   Why was that?"

Our client flushed.   "Well, Mr. Holmes, I...I...I just didn't think they were that important."

Holmes looked at her archly.  "Madam, might I suggest to you that your judgment of what is important or not leaves rather a great deal to be desired.   Facts are important, Ms. Yellen....such as the fact that you are the head of the US Federal Reserve."

Our client and I gasped simultaneously.   "But how did you kn-know..." she stammered.

"I know it all!" Holmes thundered.  "I know who you are, and I know what you've done!   Here, look at this!"  Holmes thrust a small piece of paper at our client's face.    "This was the very first Fed statement explicitly announcing interest rate policy!"

"It was short, concise, and to the point!   But look what you've done to it!" continued Holmes.   "Twisted it, stretched it, and pulled it all out of recognition.  You've destroyed it!"  He showed her another sheet of paper, upon which was printed dense blocks of text that required a font so small to fit on one page that it was illegible.  As our client squinted to read it, I heard a heavy footstep running up the stairs.

"Scotland Yard has wasted countless hours pursuing LIBOR setters and FX spot guys.  They are merely the unwitting foot soldiers of a campaign to distort and disrupt the financial system.  Ms. Yellen, the greatest manipulator of financial markets is....YOU!"

As Holmes stood and pointed at our client, Chief Inspector Lestrade appeared at the sitting room door.   Ms. Yellen appeared stunned for a moment, then a crafty glint appeared in her eye.    She feinted running behind the sofa, throwing Holmes off his guard, then charged past him and rushed at me.    As I fumbled with my revolver, she head-butted me on the hip, sending me sprawling.   Lestrade proved one obstacle too far, however, as he wrestled her to the ground and clapped restraining handcuffs upon her.

As Lestrade hauled Ms. Yellen to her feet, Holmes gazed at her with a look that almost resembled pity.  "There is a black thread of manipulation running through the colourless skein of the market, and our duty is to unravel it, and isolate it, and expose every inch of it."

"But what about the dots?" our erstwhile client screeched.  "I really was concerned about them."

"You can blame your friend the professor for that," replied Holmes.

"Faugh!" she said with visible disgust.   "And how long am I going to go down for?"

"Oh, I'd say for a considerable period," said Lestrade.  Ms. Janet Yellen blanched and gave an audible whimper as he led her down the stairs.

I sat down, shaking my head.  "For the life of me, Holmes, I cannot figure out what just happened, let alone the business with the dots.   And who is this professor?"   

My friend chuckled as he reclined on the sofa.  "These were deep waters, Watson, substantially deeper than I first supposed upon receiving the telegram.  It was obvious, of course, as I pointed out to you yesterday, that our Ms. Yellen held a senior position at the US Federal Reserve.   A quick check of the FT and Economist revealed that she had recently replaced a certain Ben Bernanke as chairman of the Open Market Committee.  Further research suggested that she had previously chaired the subcommittee on Communications.

"Her stated goal was 'transparency' of communications, but that was obviously a red herring.   Observe how poorly she was able to judge which information to emphasize in describing her case to us.  Note also how shifts in policy were communicated 20 years ago: short, succinct sentences.  Over the past few years, however, Fed policy has become a virtual Babel of messages, some of which conflict with each other.   Look at how long their last statement was, and how little it actually said.  Consider also that this statement and its guidance is just one plank of the policy platform.   Asset purchases and forecasting are also presented as policy tools.

"What I discovered is that the Federal Reserve, and indeed similar institutions like our very own Old Lady, are claiming to back efforts to enhance financial stability and do away with manipulation.   They support crackdowns in the LIBOR and FX scandals.   And yet these are the very same institutions that have suppressed volatility and risk premia more than a universe of bank traders could ever hope to do."

"But the dots, Holmes?"

"Ah yes, the dots.   In sifting through the literature, I found that that Ms. Yellen and her institution are not the mastermind of this nefarious campaign to manipulate markets.   The dots were placed there by the man at the centre of it all."

"And who is this?"

"In my study of global monetary policy over the last four years, Watson, I have become conscious of some sort of power over the manipulator, some agent who casts a veneer of academic credibility to the patently absurd.  Again and again in policies of the most varying sorts- qualitative guidance, state-contingent threshold guidance, target and policy forecasting- I have felt the presence of this force, and deduced its influence in other policies in which I have not personally been consulted.  In the end, my investigations led me to Professor Michael Woodford.

"He is the Napoleon of manipulation, Watson.   He is the organizer of half that is published and nearly all of what provides the intellectual underpinning of this trend in policy.   He is a genius, a philosopher, an abstract thinker.  He has a brain of the first order.  He sits, motionless, in the centre of a great web, but that web has a thousand radiations, and he knows very well the quiver of each of them.

"It was Woodford that convinced the FOMC that they could present explicit policy forecast guidance (for that, my dear Watson, is what those dots were), written qualitative guidance, and verbal guidance, all of which contradict each other, and still maintain the illusion of credibility."

"If it hadn't been for you, Holmes, it might have worked!"

"For a while longer, Watson.  But the agents of financial repression usually slip up in the end, and when they do, the market is there waiting for them.   Like Lestrade, the market is not always the quickest to catch on, but once it does it's like a bulldog with a bit between its teeth.  For now, we must keep a wary eye on our friend the Professor and catch him out whenever we can."


Posted by Macro Man at 7:00 AM 10 comments Links to this post  

The Mystery of the Dots

Monday, April 14, 2014

In the spring of 201- I had not seen Mr. Sherlock Holmes for more than four years.  My medical practice, which had been booming a few short years previously, was somewhat lacklustre since the epidemic of pecunia refrenata had driven so many out of the City.  Although my small roster of regular patients was sufficient to keep me in modest comfort, I often cast a wistful thought back to the days when I shared Baker Street rooms and the occasional adventure with my friend.

Holmes, meanwhile, had won global renown for his ingenious solution to that infamous affair with the QE2 and QE3.  The crowned heads of Europe regularly consulted him on matters of international importance, and he had even become something of a sensation in the gutter press.  I thought that some day he might come to call on me between cases, but sadly he never seemed to have the time.

One Wednesday afternoon in late March I had an appointment with one of my occasional patients, an elderly fellow named Mr. Jartholomew Axgrind.  This gentleman  possessed a shock of white hair and walked with a stoop, but boasted a wiry physique that would have flattered a man two decades his junior.   Cantankerous at the best of times, he was in a particularly foul mood that afternoon for someone so well-preserved as he, refusing to even let me apply a stethoscope to his surprisingly muscular chest.

"My dear sir!" I exclaimed, "if you do not wish me to examine you, perhaps you should find another doctor to consult!"

"Harrumph," he muttered, seizing his battered greatcoat and striding towards the exit, "perhaps I will.  But Watson," he said, pausing at the doorway as his voice strengthened into a familiar tone, "do you think he'd be interested in helping me with a case?"

"Holmes!" I cried, as Axgrind's stooped figure straightened to form the familiar rigid bearing of my friend.  "My dear fellow!  How have you been?  But do you mean to tell me you've been Axgrind all along?"

"I see the last few years have not dulled your powers of observation, Watson," he replied, shaking my hand warmly.  "Indeed, I took on the character of the ill-tempered Mr. Axgrind to afford me the opportunity of looking in on you every so often."

"But Holmes, why the ruse?   You know you were always welcome here!"

"Of course, Watson, but would Mr. Axgrind's fee have been as welcome if offered as charity?"  It was true that Axgrind's pecuniary generosity had always seemed a stark contrast to his irascible character, and that the income from his quarterly visits had been vital in maintaining the practice as a going concern. 

"Ah, yes Holmes, well I am very thankful indeed.  But what's this you say of a case?"

"Watson, my friend,  I received a very interesting telegram this morning that reminded me of a few all of our old adventures.   Tell me, what do you make of it?" he said, handing over a folded slip of paper.   I took it and read the message:

"Deuced if I know, Holmes.   What's this nonsense about moving dots?  I can make nothing of it, I'm afraid."

"Capital, Watson!" exclaimed Holmes.  "Scintillating!  Every single item of importance has eluded your observation."

"How so?" I inquired, wondering what even so brilliant a detective as Mr. Sherlock Holmes could make of such a cryptic message.

"As I mentioned, I received this cable this morning.  Observe, Watson, that it has been sent from Washington, DC in America.   It was, composed, therefore, in the middle of the night by the sender, this Yellen.  Who sends a transatlantic message at that hour?   Someone who is agitated in the extreme and cannot sleep, and finally resolves to consult a higher authority.   Note also that Western Union offices are closed at that time of night, and yet this person was able to access a telegraph.  That, combined with the sender's location, is suggestive of somebody that is highly placed within official circles in America.  Finally, the mention of the importance to the world economy implies that the sender is involved with business or finance of some kind.  I can think of eleven possibilities, but the one that seems most likely by far is that the sender is an official with the Federal Reserve, America's central bank."

"Genius, Holmes!  Now that you mention those things, they seem obvious."

"They are, if you know how to look."

"But what of the dots?" I asked, stroking my moustache. "You haven't mentioned them."

"Facts, Watson, we need facts!  Speculation without them is a sure path to error.  Fortunately, this Yellen has arranged transport to London and will be at 221B Baker Street at 11 am sharp tomorrow.  If you'd do me the honour of sitting in on the meeting, I am sure that we'll both find the experience stimulating."

"Naturally, Holmes!   Nothing would delight me more!"

"And now, what do you say to a nice side of mutton and a glass of claret at Rules?"

I awoke the next morning with something of a sore head.  Holmes had regaled me over dinner with stories of his adventures since I had last accompanied him, and also described the contents of his latest monograph- volatility forecasting in the context of a zero lower bound.  A glass of claret became a bottle, and one bottle became three before we stumbled out onto Maiden Lane and made our way to our respective quarters.

Mrs. Hudson welcomed me warmly when I rang the bell at Holmes' Baker Street chambers and ushered me into the sitting room at five minutes to eleven.   The famous detective appeared lost in thought and silently gestured at me to take a seat, which I did in one of the comfortable easy chairs that flanked either side of the settee.   I knew from long experience not to disturb my friend's reverie; such was the intensity of his concentration that any attempt at conversation on my part would have proven fruitless.

At 11 am sharp, the bell rang and Mrs. Hudson ushered our visitor up the stair.

"Ha!" muttered Holmes.   "A small person, as the fourth stair barely made a creak!"

This deduction was proven correct when our client entered the room.   Standing barely over five feet in height, a bowl of white hair surrounded a jovial-looking, red-nosed visage.   She (for our visitor was indeed a woman) looked much as one might picture the wife of Father Christmas, barring the fact that her attire was drab and gray rather than merry and red.

"Please have a seat, Ms. Yellen," said Holmes, gesturing to the sofa.

"Thank you, but I prefer the chair," she replied in a voice that sounded more appropriate to a Brooklyn deli than a London sitting room, and installed herself on the seat facing mine.

"Now madam, what can we do for you?"

"Well, Mr. Holmes, in December I received a strange diagram on my desk at work.  I didn't know what to make of it, for it seemed like something a child might draw as a doodle while talking on the telephone.  In speaking with my colleagues, it seems as if they all received a similar image at the same time as I did.   It was quite a sensitive period at the office as we were focused on- well, the details are not important, but starting to wind down a big project that had been an important part of our working lives for more than a year.

"No one paid much attention to these diagrams, which seemed quite meaningless.  Indeed, our target customers seemed thrilled that we were winding down our project, and things couldn't have gone much better...."

"Do you by any chance have a copy of this diagram, madam?" interjected Holmes.

"Certainly, Mr. Holmes.   I know how particular you are about evidence, and I can swear to you that this diagram is exactly as it was when it appeared on my desk."   She took a small sheet of paper from her handbag and passed it over to Holmes.   He studied it silence for a minute then handed it to me.  It looked like this:

As I handed it back to Holmes, Ms. Yellen resumed her story.  "A couple of weeks after we received the diagram, however, things started to go a bit wrong.  My boss become agitated, and the value of our most important product started to decline against those of Japanese and European competitors.   Our stock price fell sharply in early January for no reason at all.  Worst of all, our Chairman abruptly left his post at the end of that month, leaving me in charge.

"For a while after I assumed control, things seemed to return to normal.  The value of both our products and our share price rose again, and everyone seemed fairly happy despite the fact that snow had disrupted a lot of production over the first few months of the year.  While this meant that I couldn't hire as many people as I might have, on the whole things were looking pretty rosy as recently as a few days ago.

"Then, I received this on my desk."   She fished into her handbag once more, retrieving a half-eaten knish and putting it on the end table.   She then plucked a second piece of paper from the bag and handed it to Holmes.

He peered at this paper for a full ninety seconds, then compared it with the first one for another minute or so.  "What do you think, Watson?"

"Frankly, Holmes, it borders on the grotesque.  I confess I can make heads nor tails of these little dots, save that they appear to be a bit higher in the second diagram than in the first.  If anything, it reminds me of the adventure of the dancing men, which if memory serves also involved America."

"Yes, and with tragic consequences, if you'll recall, Doctor.  Tell me, Ms. Yellen, has anything untoward happened since you received this second diagram?"

Our client sighed and slumped in her chair.   "I'm sorry to say that it has, Mr. Holmes.   Although my colleagues have once again claimed that these dots can mean nothing, and that there is no significance in their movement, as soon as we got the diagrams, things have started turning south again.  This time, it's the value of our bonds that have plummeted.  I mulled over the problem for a considerable period but could come up with nothing to do, so thought I had better consult an expert- you."

"Very interesting, very interesting indeed, Ms. Yellen.  I am much obliged to you for bringing this  curious matter to my attention.   Allow me to think on it for while, so I suggest you return here at the same time tomorrow.    In the meantime, you might wish to see the sights of London.    I hear Threadneedle Street is very interesting these days."

As Mrs. Hudson ushered our guest downstairs, Sherlock Holmes looked at me with a glint in his eye.   "This is a real corker, Watson, at least a two pipe problem.  Be a good chap and fetch me a copy of the Financial Times and The Economist  from the corner shop, will you?"

While strolling on the familiar stone of the Baker Street pavement, I found myself wondering what meaning Holmes could possibly find in those bizarre, and quite possibly sinister, dots.


To be continued.....

Posted by Macro Man at 7:00 AM 10 comments Links to this post  

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