One of the fundamental tenets of effective central banking is independence from meddling politicians. While in most countries, a nominated head of the central bank must be given confirmed by the national legislature, it is generally regarded as detrimental for the government to be meddling in the decision making process of the central bank. That being said, high-level political oversight of central bank operations is a necessity.
After yesterday's shock and awe announcement from Europe's leadership which includes: 60B euros in government bond purchases by the ECB; 440B euros in loans or guarantees; as well as potentially 250B euros from the IMF (read America), I have yet to read any reaction to the apparent loss of ECB independence from Europe's politicians. Just last Thursday, Trichet stated unequivocally in a Q&A period that ECB purchases of government bonds had not been discussed at the most recent rate decision. Then in a complete 180 on the issue, on Sunday evening the ECB announced that they will be buying government bonds (along with the reintroduction of a number of liquidity facilities).
Admittedly, market volatility was very high Thursday and Friday, and the liquidity facilities existed during the earlier financial crisis. That being said, I am having an awfully hard time believing that the ECB did a complete 180 on the topic of QE over the course of one and a half trading days without enormous pressure from Euro zone politicians. If my convictions turn out to be rooted in fact, such overt political meddling does not bode well for the future of effective central banking.
Monday, May 10, 2010
Saturday, May 8, 2010
Thursday's Sell Off
I don't think I have ever felt my heart sink into my stomach the way it did when I was watching the chaotic sell off at 2:45 on Thursday afternoon. I literally thought that there had been another major terrorist attack, or a natural disaster orders of magnitude more severe than the oil spill in the Gulf (I do not mean to make light of the Gulf situation, but it's market impact thusfar has been relatively limited). Many market commentators and participants have blamed a "fat finger" putting in a sell order for 6 billion shares of P&G instead of 6 million. This may or may not be true, but it is ignoring the much more important issue. Once P&G started tanking, the rest of the market waterfalled with it, with the Dow down nearly 1000 points in literally minutes. The culprit is clearly algorithmic trade machines.
For those unfamiliar with the basics of how such programs work, they effectively trade securities based on the historical correlations between them. So if asset X drops historically in tandem with asset Y, and on a given day asset Y drops, algorithmic trading will exploit the 'mispricing' of asset X and short it based on the historical relationship between the prices of the assets. Then assuming a third asset (Z) historically falls when asset X swoons, another (or perhaps the same) algorithmic trading program will sell asset Z. These trading programs, combined with an erroneously large sell order which caused P&G to drop enormously (providing the spark), resulted in a positive feedback loop with enormous impacts on asset markets across the board. In this particular case, cooler heads prevailed and markets closed within spitting distance of where they were before this unprecedented sell off, but with trading trending in an increasingly automated direction, the next situation may not end so happily. In my opinion, the powers that be in financial markets want to distract attention away from the potentially enormous adverse impact of algorithmic trading, which provide very little economic value added to markets. This is why we are hearing more about a fat fingered trader in P&G than about algorithmic trading when this sell off, which is unprecedented in combination scope and speed, is discussed.
I don't want this rant against algorithmic trading to be understood as opposition to the high-frequency trading we were hearing about last summer where programmers equipped with the most sophisticated computers were supposedly front running the orders of, and thereby ripping off, institutional investors. These allegations are a complete misrepresentation of the reality of how such traders operate.
For those unfamiliar with the basics of how such programs work, they effectively trade securities based on the historical correlations between them. So if asset X drops historically in tandem with asset Y, and on a given day asset Y drops, algorithmic trading will exploit the 'mispricing' of asset X and short it based on the historical relationship between the prices of the assets. Then assuming a third asset (Z) historically falls when asset X swoons, another (or perhaps the same) algorithmic trading program will sell asset Z. These trading programs, combined with an erroneously large sell order which caused P&G to drop enormously (providing the spark), resulted in a positive feedback loop with enormous impacts on asset markets across the board. In this particular case, cooler heads prevailed and markets closed within spitting distance of where they were before this unprecedented sell off, but with trading trending in an increasingly automated direction, the next situation may not end so happily. In my opinion, the powers that be in financial markets want to distract attention away from the potentially enormous adverse impact of algorithmic trading, which provide very little economic value added to markets. This is why we are hearing more about a fat fingered trader in P&G than about algorithmic trading when this sell off, which is unprecedented in combination scope and speed, is discussed.
I don't want this rant against algorithmic trading to be understood as opposition to the high-frequency trading we were hearing about last summer where programmers equipped with the most sophisticated computers were supposedly front running the orders of, and thereby ripping off, institutional investors. These allegations are a complete misrepresentation of the reality of how such traders operate.
This Week in Europe
Okay, so a lot of things have happened since I last checked in with the situation in Greece. Where do we start? The upsized EU-IMF bailout is a good place. For those who have been under a rock for the last week, Sunday the EU and the IMF issued a statement detailing a 110 billion euro package of loans (at around 5% interest) for Greece, effectively removing them from private funding markets for the next two and a half years. The loan schedule was contingent on Greece implementing a strict set of austerity measures. Also included in the plan were much more realistic economic forecasts, in which the debt to GDP ratio peaks at 149% in 2013, falling from that point. Other bloggers/sites have told the story of last week better than I could here, so I will only comment on the broader issues behind this package.
It strikes me that the package announced by the EU/IMF will only serve to stave off a default by Greece (which would occur when their next bond matures on May 19th without the package). Why is default still inevitable? To answer this question, we must revisit our math on sustainable soveriegn debt loads. Assuming that Greece achieves trend growth of 2%, and that their average cost of debt is 5% (resulting in interest payments of 7.5% of GDP), it would be necessary for Greece to achieve a primary surplus of 5.5% in order to stabilize the debt/GDP ratio. Greece has never achieved this. So why lend them money at all? Well it appears to me that the idea was to prevent contagion until the other peripherals (who’s debt/deficit statistics aren’t as ugly as those of Greece) got their collective acts together and stabilized their fiscal situations – essentially to buy time for the other peripherals. I hope nobody at the EU-IMF summit was kidding themselves about Greece’s ability to achieve the fiscal consolidation necessary to avoid a debt spiral. The calculus appears to have been that the loss which will results from the restructuring of Greek sovereign debt (more on this later) will be outweighed by the ‘cost savings’ of preventing similar crises in Spain, Italy, Ireland and Portugal. This struck me as a relatively reasonable approach to mitigating the impacts of the crisis, despite the enormous agency problems it introduced for the peripherals. Too bad the Greeks ruined it all by rioting and shaking the market’s confidence in Greece’s ability to implement the austerity program and thereby putting enormous market pressure back on the remaining peripherals, with the chaotic results we witnessed in markets this week.
It strikes me that the package announced by the EU/IMF will only serve to stave off a default by Greece (which would occur when their next bond matures on May 19th without the package). Why is default still inevitable? To answer this question, we must revisit our math on sustainable soveriegn debt loads. Assuming that Greece achieves trend growth of 2%, and that their average cost of debt is 5% (resulting in interest payments of 7.5% of GDP), it would be necessary for Greece to achieve a primary surplus of 5.5% in order to stabilize the debt/GDP ratio. Greece has never achieved this. So why lend them money at all? Well it appears to me that the idea was to prevent contagion until the other peripherals (who’s debt/deficit statistics aren’t as ugly as those of Greece) got their collective acts together and stabilized their fiscal situations – essentially to buy time for the other peripherals. I hope nobody at the EU-IMF summit was kidding themselves about Greece’s ability to achieve the fiscal consolidation necessary to avoid a debt spiral. The calculus appears to have been that the loss which will results from the restructuring of Greek sovereign debt (more on this later) will be outweighed by the ‘cost savings’ of preventing similar crises in Spain, Italy, Ireland and Portugal. This struck me as a relatively reasonable approach to mitigating the impacts of the crisis, despite the enormous agency problems it introduced for the peripherals. Too bad the Greeks ruined it all by rioting and shaking the market’s confidence in Greece’s ability to implement the austerity program and thereby putting enormous market pressure back on the remaining peripherals, with the chaotic results we witnessed in markets this week.
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