HFT, Rigged Markets and The Man

by Doug Noland

April 4, 2014

Initial indications of greed giving way to fear

April 3 – Bloomberg (Silla Brush): “The U.S. Commodity Futures Trading Commission is reviewing futures markets to ensure high-speed trading isn’t violating the law, acting CFTC Chairman Mark P. Wetjen told reporters‘I don’t have the impression at the moment that futures markets are rigged,’ Wetjen said… He was responding to comments by Michael Lewis, author of the bookFlash Boys,’ that investors are being robbed by traders using advanced computers to jump ahead of their trades.”

Charles Schwab stated that “High-frequency trading is a growing cancer that needs to be addressed High-frequency traders are gaming the system, reaping billions in the process and undermining investor confidence in the fairness of the markets.”

I’m definitely no fan of high-frequency trading (HFT). Still, it’s difficult for me to get all that worked up on this particular issue. I guess I’ve seen too much during my going on 25 years in the financial markets. This week Michael Lewis created a firestorm with his assertion that markets are “rigged.” Are they rigged? There is clearly a prevailing riggingelement, yet the high-frequency traders are bit players. HFT is symptomatic. They’re not the “cancer.”

Credit is inherently unstable. Always has been. History has also clearly demonstrated that stock markets are prone to destabilizing bouts of exuberance, intense speculation and spectacular boom and bust cycles. Nurture a Credit system dominated by marketable instruments and you’ve created a highly unstable Credit mechanism. Allow marketable securities to inflate to 400% of GDP and you’ve created highly unstable financial and economic systems. Push everyone into a securities market Bubble and then you’re really trapped. Policymaker rationalizations and justifications even foster the delusion that rigging markets is good and reasonable policy.

As noted above, I’ve witnessed too much. I recall 1993bondmarket excesses as if they were yesterday. Late-eighties (“decade of greed”) excess junk bonds, M&A, S&L fiasco, coastal real estate Bubbles, etc. left the U.S. banking system deeply impaired. Fed chair Greenspan cleverly fashioned a steep yield curve to covertly bail out the banks, in the process providing the fledgling hedge fund industry a speculative profit windfall. Seemingly, market rigging had worked miracles. Then a little 25 bpsbaby steprate increase in February 1994 unleashed bloody havoc throughout Treasury, MBS and derivatives markets (not even to mention Mexico).

The early-nineties was a critical period for the interplay between policymaking and increasingly speculative financial markets. The activist Greenspan Federal Reserve promoted market-based Credit (MBS, ABS, securitizations, derivatives, etc.) to help compensate for the banking system’s incapacity to provide sufficient Credit to the real economy. The symbiotic relationship between the leveraged players and GSE securities took root. But as 1994 demonstrated, all this New Age speculative leverage was acutely susceptible to interest-rate uncertainty, de-leveraging and a highly unstable (boom & bust) liquidity dynamic.

I was never comfortable with the Fed’s push to so-calledtransparency.” For me, it was fundamental to the “Maestroassuming too much control over the financial markets. Indeed, never had a central bank enjoyed such dominance over finance. Greenspan could spur stock and bond market rallies (wealth creation!) with a simple utterance on rate policy. For the economy as a whole, Credit Availability and, more generally, “financial conditionsbecame chiefly dictated in the securities markets – and the Fed chairman had powerful new levers to govern market behavior.

Greenspan moved forward with transparently pegging short-term interest rates. Moreover, he made it clear that he would allow the markets to run on the upside (pro-Bubble) while promising to aggressively cut rates and inject liquidity if markets faltered to the downside (Bubbles burst). The hedge fund community took off, the GSEs took off, derivatives took off, “Wall Street financetook off and a historic Credit Bubble took flight. Stocks, bonds, derivatives and system Credit all became rigged” to the upside. The markets buckled briefly in 1998 (the LTCM collapse) and on a somewhat more extended basis in 2000; potential critical market junctures that were rectified through progressively more aggressive market intervention.

The 2008 crisis was another critical juncture in a financial Bubble that had inflated to systemically dangerous proportions. The “riggedmarket throughout mortgage finance collapsed with predictable consequences for the leveraged players, asset markets and real economy. The Fed and Washington rushed to bail out a system that had clearly turned highly dysfunctional and maladjusted. Bernanke moved aggressively with his “helicopter money” and “government printing press.” Fatefully, Washington took an even larger role throughout the economy and markets.

Oblivious to its previous policy failures, the Federal Reserve’s rigging” of the financial markets became only more prominent and purposely conspicuous. Since 2008 the Fed has ballooned its balance sheet from $900bn to $4.3 TN with the stated intention of inflating stock and bond prices. They took their market liquidity backstop role to a whole new level. The Fed has also taken interest-rate transparency” into uncharted waters. This is all part and parcel to the “riggedfinancial markets I worry deeply about.

When I started with my career in the markets, the hedge fund industry was thought to be less than $40bn. It had grown 10-fold by (party like it’s) 1999. Estimates have hedge fund assets surpassing $3.0 TN this year. “Sovereign wealth fundsweren’t a force in the nineties. The exchange-traded fund (ETF) industry didn’t even exist. These days, after doubling in four years, ETF assets total $2.4 TN. A headline from the upcoming weekend’s Financial Times caught my eye: “High Drama in Murky Link Between ETFs and HTF.” And when it comes to “murky links,” I suspect the equities derivative marketplace is today bigger and more impactful than ever. Over recent years, there has been a proliferation of instruments and products that make it so easy to jump on board the raging bull. There are these days Trillions of speculative finance playing little more than trend-following strategies. The market is going up – the Fed is ensuring it goes upso buy. Leverage makes for higher returns.

From my perspective, government rigging the cost and quantity of finance for more than 20 years guarantees that lots of unsavory things are going to develop (fester). For one, asset prices throughout the system will be subject to gross mispricing. Risk misperceptions will become deeply entrenched. To be sure, pegged rates and liquidity backstops incentivize leveraged speculation. Those best at playing the gameparticularly the champions at anticipating monetary policygrow to incredible size. Those with the best government connections (in the U.S., Europe, Asia and EM) have a decided advantage over the rest of us. And as a limited number of powerful market operators dominate, traditional market trading dynamics give way to speculation more akin to a poker game (with chips piling up on one side of the table – the unsuspecting up against “the family”). There was clear justification for the government moving aggressively (Glass-Steagall) to rein in the big and powerful financial institutions after the devastating collapse of the “Roaring TwentiesBubble.

And as the media fixated this week on HFT, market internals seemed to indicate some concern for the health of the U.S. stock market Bubble. Friday’s trading session began with yet another S&P500 record high – but ended with some blood on the street. Many prominent Bubble stocks were under intense selling pressure.

In market analysis over the years, I’ve noted the “crowded tradedilemma. Too much speculative (“hot money”) finance gravitating to one sector or asset class significantly alters the nature of the marketplace. Trading becomes more speculative, prices increasingly unstable and the market in general much more prone to boom and bust dynamics. QE3 ensured a major influx of destabilizinghot money” and a highly speculative U.S. equities market akin to one gigantic crowded trade.” The bulls have enjoyed a great run. At least in the high-flyers, the downside of “price instability” has rather quickly become a pressing issue.

Federal Reserve Bank of Dallas President Richard Fisher offered valuable insight Friday in remarks before the Asia Society in Hong Kong. I’m providing extensive excerpts, but I strongly encourage readers to study his entire speech available at the Dallas Fed’s website. Mr. Fisher has risen to become a dominant force in the evolving monetary policy debate. He’s now The Man.” There was even mention Friday on CNBC of the possibility of a future Fisher Fed Chairmanship. Count me as a strong supporter. For now, it’s encouraging to pull sound monetary policy thinking from a U.S. policymaker.

From Richard Fisher’s “Forward Guidance,” April 4, 2014: The Fed’s large-scale asset purchases dramatically and more broadly impacted credit markets. The U.S. credit markets are awash in liquidity. As of March 14, our par holdings of fixed-rate MBS exceeded 30% of the outstanding stock of those securities… We now own just shy of 24% of the stock of Treasury coupon securities. Having concentrated our purchases of Treasuries further out on the yield curve, and done so in size, we have driven nominal interest rates across the credit spectrum to lows not seen in over a half century.

This has allowed U.S. businesses to restructure their balance sheets, manage their earnings per share through share buybacks financed with bargain-basement debt issuance, bolster stock prices through enhanced dividend payouts and position themselves for financing growth once they see the whites of the eyes of greater certainty about their economic future. By driving nominal interest rates to half-century lows, we have also reduced the hurdle rate by which future cash flows of publicly traded businesses are discounted. Thus, through financial engineering, we have helped bolster a roaring bull market for equities: The indexes for stocks have nearly tripled from the lows reached in March 2009.

Alongside these signs of rebound have been some developments that give rise to caution. I have spoken of these in recent speeches, echoing concerns I have raised in FOMC discussions: The price-to-earnings (PE) ratio of stocks is among the highest decile of reported values since 1881. Bob Shiller’s inflation-adjusted PE ratio reached 26 this week as the Standard & Poor’s 500 hit yet another record high. For context, the measure hit 30 before Black Tuesday in 1929 and reached an all-time high of 44 before the dot-com implosion at the end of 1999Since bottoming out five years ago, the market capitalization of the U.S. stock market as a percentage of the country’s economic output has more than doubled to 145%—the highest reading since the record was set in March 2000. Margin debt has been setting historic highs for several months running and… now stands at $466 billion. Junk-bond yields have declined below 5.5%, nearing record lows…. In my Federal Reserve Districtbankers are reporting that money center banks are lending on terms that are increasingly imprudent.

The former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability… At the current reduction in the run rate of accumulation, the exercise known as QE3 will terminate in October (when I project we will hold more than 40% of the MBS market and almost a fourth of outstanding Treasuries)…

Enter Forward Guidance. This is no small matter. Quantitative easing has made life easy not only for corporate treasurers and homeowners and consumers burdened by debt, but also for money market operators. It has run up the price of stocks and bonds mostly in straight-line fashion, and it has taken volatility out of the marketplace, allowing market operators and their clients to profit with little effort. The question of when and under what conditions the FOMC will begin to raise the base rate off the floor is understandably of intense interest.

Research papers have addressed this subject. For example, some academic economists draw on Greek mythology to distinguish different techniques for crafting forward guidance, making a distinction between Odyssean and Delphic forms of guidance. The Odyssean model involves committing to a policy rule or to a criterion for choosing between different policy alternatives. Policymakers tie themselves to the mast of this rule or criterion, sacrificing some of their short-run freedom of action in order to achieve what they hope will be superior outcomes over the long term

Commitments come in lots of different flavors and styles, and forward guidance isn’t necessarily helpful or wise just because it’s Odyssean. Tying yourself to the mast isn’t an especially good idea if your ship is sinking, or if enemy forces are directing fire toward your deck. Committing to a particular path for the funds rate, or to a time schedule for funds-rate liftoff, is not something in which I or many of my colleagues have any interest

My own view is that commitments aren’t always credible, especially if they purport to extend far into the futureAs a general rule, then, the further into the future a commitment extends, the vaguer it tends to be. Along these lines, the FOMC periodically reiterates its commitment to do what it is legally mandated to do: pursue full employment, price stability and a stable financial system

Delphic forward guidance is less binding than Odyssean guidance. Like the responses of the oracle of Apollo at Delphi, it is more obscure, more enigmatic. It amounts to saying, ‘Here’s what we think we are going to want to do if the economy evolves as we currently expect.’ Delphic guidance clarifies your current thinking about future policy without making any promises—even contingent promises. Our current FOMC statement is chock-full of Delphic guidance

As a former practitioner, I can tell you that market operators prefer Odyssean guidance to Delphic guidance, and within the Odyssean model, tend to prefer inflexible, calendar-based guidance to guidance that’s either conditional or qualitative. Life in my former incarnation would naturally be much more pleasant if I could dial in the specific dates and levels of interest rate movements. But as a central banker, I am haunted by a comment made by Winston Churchill in 1926, shortly before things began to unravel in the global financial markets. Speaking at the Waldorf Hotel in London, he said: ‘In finance, everything that is agreeable is unsound and everything that is sound is disagreeable.’

I worry that the predictability of calendar-based commitments can quite possibly be unsound in two key dimensions. First, the quantitative moorings may be misplaced—especially given shifts in economic relationships following the worst downturn since the Great Depression. Second, I question if it is sound policy to remove all uncertainty or volatility from the market. I wonder whether being totally predictable may, at best, lead to a false complacency that can too easily be upset should we need to change course. At its worst, I fear calendar-based commitments can lead, perversely, to market instability by encouraging markets to overshoot, as they appear to be doing in some quarters at present… The point is: Forward guidance can be a complicated monetary policy tool

This is the very best we can offer you Those who think we can be more specific in stating our intentions and broadcasting our every next move with complete certainty are, in my opinion, clinging to the myth that economics is a hard science and monetary policy a precise scientific procedure rather than the applied best judgment of cool-headed, unemotional decision-makers.”

The future for real interest rates

by Gavyn Davies

April 6, 2014 11:25 am 

The OECD pointed out last week that the ratio of public debt/GDP will reach all time historic highs in 2014, at about 120 per cent. Taken in isolation, this could certainly viewed as a worrying fact, with bad implications for the future of real interest rates and possibly inflation. A couple of days later, however, the IMF published a fascinating chapter in its latest World Economic Outlook (WEO) on global real interest rates, showing that the global real rate has fallen from about 6 per cent in the early 1980s to about zero today.

Both of these facts are of course very well known, but placed side-by-side, they still represent a stark contrast:

They also present a conundrum for policy makers and investors. Why has the surge in public debt not resulted in a large rise in real borrowing costs for the government, and for the wider economy? And what does this tell us about the future of the risk free real rate in the global economy?

The risk free rate is the bedrock of asset valuation, and is often presented as one of the great constants” in economic models. But in the past few decades, it has been anything but constant.

Mainstream macro-economic theory assumes that the global real interest rate is determined in the market for capital or “loanable funds”. An upward shift in the demand for capital (from higher investment or more public debt) will raise real rates, and a rise in the supply of capital (from higher savings) will reduce them.

Empirical studies generally confirm that the positive association between public debt and real rates, expected in theory, does indeed exist (though this is controversial and not well pinned down). Therefore the strongly negative relationship between the two variables since 1983 is certainly a prima facie puzzle.

The solution lies in the ceteris paribus”, or other things equal, clause implicitly inserted into all economic models. Other things, in this case, have certainly not been equal. While the rise in public debt, taken on its own, would probably have increased real rates, other economic forces have worked more powerfully in the opposite direction.

The IMF says that the main reason for the drop in real rates in the 1980s and 1990s is obvious: the easing in monetary policy that occurred after the 1979-82 Volcker tightening. After 2000, the IMF identifies other forces, each of which is associated with a different school of economic thinking:
  • A drop in investment demand in the advanced economies. This is very similar to the secular stagnation hypothesis, recently advanced by Larry Summers and Paul Krugman. On this view, real rates have been reduced by low rates of investment, which are in turn due to the global recession post 2008 and to the IT revolution. The latter has cut the prices of investment goods (think more computers and less steel mills), and this has cut the demand for loanable funds. The IMF says that these effects are unlikely to be reversed very rapidly in the years ahead. In fact, they expect the investment ratio in the advanced economies to stay well below pre-crash levels, while the savings ratio begins to rise moderately. Overall, this might even exert some downward pressure on real rates from here.
  • An excess of savings in the emerging economies. This view is mainly associated with Ben Bernanke, who warned of a global savings glut in 2005. This shifts the supply of loanable funds to the right, also reducing real rates. The IMF says that this factor was particularly important from 2002-07, and warns that it may reverse somewhat in the next few years, exerting some upward pressure on real rates.
  • A portfolio shift towards bonds and away from equities. This view, associated with John Campbell and others, suggests that the increased volatility of equities after the 2000 crash, along with a drop in the inflation risk premium on bonds as monetary policy credibility has improved, has increased the demand for bonds and depressed the real rate. Many investors seem to think that this shift will be reversed in the year ahead, with a “great rotationaway from bonds. But the riskiness of equities is not declining, and the inflation risk premium on bonds is not rising, so the chances of a major reversal in this factor also look to be limited.
  • There is much more on each of these forces in the WEO chapter, but the major point is that together they are capable of explaining why the rise in public debt has been contemporaneous with a major drop in real rates, not just recently, but progressively for three solid decades.

The IMF has been rather coy in presenting its overall findings in a coherent summary table, presumably for internal political reasons. (Paul Krugman complains of IMF euphemisms”.) I have therefore tried to summarise the research in the table above, piecing together various statements in the paper, along with the video summary presented by the IMF’s Andrea Pescatori last week (well worth watching here).

Note that the causes of the drop in real rates vary through the different eras, but together they exert downward forces which swamp any upward impact from the rise in public debt. Note also that quantitative easing by the central banks is hardly mentioned at all among the forces that have held real rates down, which is interesting in view of the amount of attention it has received from investors since 2008. It seems odd that the IMF has assigned almost no importance whatever to QE, but it certainly cannot be the main factor, since two-thirds of the fall in real yields occurred before QE even started.

All this has clear implications for the future. The IMF has been too cautious to highlight its projected path for real rates in the published chapter of the WEO, but the graph above appears briefly in the video.

It shows the global real rate rising from 0.5 per cent now to only 0.5-2.0 per cent by 2018. Even at the high end of this band, this means that the global real rate will remain well below the growth rate of global real GDP throughout the medium term horizon.


The full implications of this research are profound, and they require a more complete treatment in a later blog. But three conclusions are obvious:

1) If the global real long term rate rises to only 1.25 per cent in 2018, the equilibrium nominal bond yield (with inflation expectations at the 2 per cent target) will be only 3.25 per cent, suggesting that any further bear market in bonds will be limited in scale from here.

2) The equilibrium real short rate in the next era should be well below the 2 per cent built into conventional monetary policy rules prior to 2008. This will restrict the extent of central bank tightening up to 2018 (assuming that Ms Yellen et al believe this research, as they probably do).

3) Those of us who have been worried about the rise in public debt in Japan, the UK and the euro area periphery (not the US or the euro area as a whole) may have been exaggerating the risks that budgetary policy in these regions is in imminent danger of becoming unsustainable. More on this another time.