Three myths

It is month and quarter end (and indeed year end, if you're Japanese) today, which should provide all sorts of fun and games for markets. Expect plenty of volatility around fixing/closing periods as fund managers scramble to hedge/window dress their portfolios to appear as attrative as possible for their monthly/quarterly reporting requirements.

Macro Man can only hope that he holds on to his remaining profits for the month; it would be nice to register positive performance for each of the first three months of the year. A window dressing rally in the SPX would be just the ticket...

Financial markets are home to a number of myths and legends. Some of these refer to specific traders or trades (George Soros' sale of sterling in 1992, for example.) Others refer to apparent market phenomena. The last business day of March, for example, used to regarded with a mixture of awe and dread, such was the supposed influence that Japanese fiscal year end flow was purported to have on asset markets. Fortunately, a combination of regulatory adjustments and time have reduced the resonance of the fiscal year end myth, though it is still believed in some quarters.

Today, Macro Man would like to address three market myths and (briefly) attempt to debunk them.

Myth 1: The Fed is flooding the money market with liquidity to prop up the stock market.

This appears to be a popular theory among certain segments of the retail market, and message boards on popular blogs are frequently littered with references to Fed repo actions as "proof" of market manipulation by the Fed. While Macro Man holds no great love for Ben Bernanke, accusations of corrution, et al are well wide of the mark.

Daily Fed repos are not evidence of propping up the stock market; they are the instrument that the Fed uses to keep short term rates around the Fed funds target. Moreover, the ratio of repo awards to submissions has been relatively constant over a long period of time, except on the rae occasions that the Fed does wish to flood the market with liquidity. See, for example, if you can find September 11 and its immediate aftermath on the chart below. Suggestions that the Fed is propping of equities via the repo market are a myth.
Myth 2: Higher oil = lower dollar; lower dollar = higher oil

There is a popular theory that the dollar and the oil price are inextricably linked and highly negatively correlated. The naive version of the theory implies a high foreign price elasticity of oil demand, and that as the dollar weakens non-US entities will susbtantially increase the volume of their oil consumption, thus dramatically increasing the price in dollar terms. In fact, there is a large body of evidence suggesting that the opposite is true, and that demand for oil is highly price inelastic.

The more subtle version of the theory is that the owners of crude receive (primarily) dollars for their exports, but consume and invest in a currency basket that has a substantially lower dollar weight. This is clearly a factor at the moment, as certain oil exporters are among the most enthusiastic sellers of dollars/buyers of euros in the market today. The question left unanswered, of course, is who is buying the oil, and where do they get the dollars to pay for it?

It wasn't that long ago, for example, that European dollar demand to pay for oil was being blamed for a trend decline in the EUR/USD rate- how times have changed! Looked at from a longer term perspective, however, there has been very little stable correlation between the dollar and oil. The 2 year rolling correlation between the dollar's real effectiuve exchange rate and oil has been both strongly positive and strongly negative over the past 20+ years, and the long term average is -0.07: hardly evidence of a strong causal relationship.

Myth 3: My clients are making money

Macro Man occasionally enquires with sales people across various asset classes how their customers are doing. When market conditions are favourable, most clients appear to shoot the lights out by being limit long. Whan conditions turn turbulent, clients are generally a bit bummed because they take profits on their net shorts a little prematurely, thus limiting their gains. Remarkable! If brokers are to be believed, their clients switch from limit long to net short at virtually the high tick of any market.

The reality, it would seem, is somewhat different. Macro Man recently became aware of an index that measures the performance of 60-70 currency managers to whom Deutsche Bank allocates some capital. The index measures just their trading performance, not the returns from holding cash. Macro Man isn't sure how many currency managers exist, but he has to believe that 60-70 represents a statistically significant sample size of the universe. The performance over the last year suggests that investment performance is rather different from that suggested by brokers.

Hopefully, Macro Man's March P/L won't look similar by the end of the day....