September 17, 2014

Forward Guidance, Asymmetric Information and Ms. Yellen

Forward-Guidance-1According to the FED the easiest and most important aspect of its program to ease ‘fear’ in the markets is its communication policy, which is often called “forward guidance.” This consists of the FOMC minutes, which are made public and from where the board lays out, and reiterates policy complete with a timeline for implementation and duration or targets to be reached.

Investopedia defines forward guidance as:

Verbal assurances from a country’s central bank to the public about its intended monetary policies. Forward guidance attempts to influence the financial decisions of households, businesses and investors by letting them know what to expect from interest rates (to the extent that the central bank can influence those rates). The central bank’s clear messages to the public are one tool for preventing surprises that might disrupt the markets and cause significant fluctuations in asset prices. Forward guidance is a key tool of the Federal Reserve in the United States. Other central banks, such as the Bank of England, the European Central Bank and the Bank of Japan, use it as well.

Asymmetric_information_lInvestopedia defines asymmetric information as:

A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge. 

FederalreserveToday the FED made known its minutes from the last BOD, (Board of Governors) meeting. Having an understanding or what some may consider, “a situation in which one party has more or superior information compared to another.” What I mean by this is that is seemed clear that the FED released the minutes highlighting precisely what the news scraping algorithms would consider as “dovish” or bullish for the markets.

Case in point, the statement that the “interest rates are likely to stay low for a “considerable time: after it ends its bond-buying program in October, but the central bank also took concrete steps to prepare for an increase some time in 2015. “ Most algorithms ran with the first half of that sentence with some running in the other direction with the word, “but” being picked up. Also lost somewhere in the release were the central bank’s vote to stick to current “go-slow” policy on raising rates drew two dissents, a first since Ms. Yellen took over as chairwoman in February. Leave it to the Fed to be cautious, in attempting to avoid setting off a market countdown to its first rate hike. What – are you kidding me? Did anyone notice the bond markets reaction?

Let’s break this down – is the Fed really playing a bad game of chicken with reality and their ability to control the inevitable? I dare say yes, while believing that they somehow have the power to contain or stop it. The more hawkish presidents of the Dallas and Philadelphia Fed banks continue to argue that rates will “likely” have to rise sooner than later, while the majority of analysts still believe the first rate increase will come mid 2015 and that the majority (of board governors?) is understating the improvement in the U.S. economy. Sounds somewhat like asymmetric information to me.

Now here is where the pundits really made me laugh – reading from MarketWire:

“By leaving in the language about a “considerable time,” the Fed signaled it’s still not prepared to raise the fed funds rate earlier than markets expect. Keeping the language was seen as a victory for the doves on the committee. The rate has hovered near zero since 2008.”

What wasn’t included was President Fisher’s (hawkish and voted against the FOMC monetary policy) belief that the continued strengthening of the real economy, improved outlook for labor utilization and for general price stability, and continued signs of financial market excess, will likely warrant an earlier reduction in monetary accommodation than is suggested by the committee’s stated forward guidance.

Nor was President Plosser’s (hawkish and voted against the FOMC monetary policy), objections to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.

The market’s reaction makes more sense if the majority continues to buy the concept that the continuance of cheap money is reliant on the premise that the economic recovery or economic progress is not to be believed and therefore cheap money will continue to flow unabated for the foreseeable future with no place to go but the equity markets. Now think about it, if we are to believe the economy isn’t improving, but somehow corporate profits and revenues are and will remain on a steady climb who is passing out asymmetric information and who believes it hook line and sinker?

yellenakerlofIt should be noted that it was Ms. Yellen’s husband, George Akerlof who in 1970 wrote “The Market for Lemons: Quality Uncertainty and the Market Mechanism”. Within his thesis Akerlof discusses information asymmetry, which as defined above is a “situation” whereby one side of the transaction has more or better information than the other. Akerlof describes how the interaction between quality heterogeneity and asymmetric information could create the elimination or disappearance of a market where guarantees are indefinite.   The implications of Akerlof’s work are applicable and have been applied to numerous problems and are at its core very profound. Think about it if communication is improved and information asymmetries reduced markets would become more efficient and function more smoothing, which ultimately reduce costs to consumers.

From his 1980 paper, “Irreversibility, Uncertainty, and Cyclical Investment” a young Ben Bernanke addressed the decision-making process behind an investment by asking how uncertainty as it applies to future policy and business conditions, impedes such investment. Mrs. Yellen then has learned from some of the best when it comes to asymmetrical information and forward guidance.

janetyellenHere are some great “tag” lines from Federal Reserve Chair Janet Yellen testimony after Wednesday’s monetary policy statement.

Yellen says, ” ‘Considerable Time’ provides the Fed flexibility.”

            Yellen states, “Fed not behind the curve, low rates aid growth”

OK, but again what isn’t included is that “low rates aid growth” by devaluing the currency, artificially inflating prices and understating inflation as massive amounts of new currency are pumped into the system. Clearly this is an unsustainable plan that cannot go on indefinitely. The Fed somehow believes it still has the power to control things but left unchecked it will ultimately lead to hyperinflation, a rapid interest rate rise, and a rapid decline in the stock markets.

Yellen said, “The labor market continues to make “gradual progress” towards the Fed’s objective, but still hasn’t recovered.”

Could be due to the continued loss of full time jobs that are replaced by part time jobs, which allows corporations due bank money not spent on benefits. So in reality the number of unemployed is actually increasing when all is said and done.

Yellen said, “Third quarter GDP appears to be expanding at a moderate pace.”

And then..

Yellen said, “Inflation has “firmed some” since earlier in the year, and said the FOMC sees a decreased likelihood that inflation will continue to run below 2%”, (the Fed’s stated inflation goal.)

And somewhat buried in her testimony..

Yellen said, “that the Fed also intends to reduce its holding gradually as it sees appropriate.”

This is where you need to remember who holds the largest positions in U.S. equities and treasuries – yes it is the Fed and U.S. Treasury. Do you really believe they are going keep propping up the markets to benefit the TBTF banks and Wall Street and not sell their own positions to an unsuspecting crowd of misinformed believers? I don’t! Can you say asymmetric information?

risingstocksBroader Market Reaction

Initially, the broader indexes gave a quick positive nod to the FOMC announcement, which was followed by a serious drop across the board, which was then followed by an even more serious jump to new all time highs in the DJIA, while the SPX came within a point and the NDX within 20 points. Treasuries initially also rallied to session highs before getting crushed as the traders doubted the statement and testimony from Yellen. Remember, as goes interest rates so goes the stock market. Thus as bonds began to get pounded lower the equity markets marched back to levels pre Fed announcement. The real reaction though, isn’t likely until Thursday after everyone has time to digest all the double speak.

Unfortunately, the moves themselves were not really tradable for most traders as it appeared algorithmic computers had gone wild. The reaction and subsequent market gyrations were a strong testament to why you keep your hands in your pockets after a FED announcement is made. Again, the pent up trading energy was released with such great force that prices were changing so quickly that many monitors could not keep up as the indexes were jumping higher and lower by $5 to $10 at a clip in the NQ and YM and $3 to $4 in the ES. Even after it appeared that things had calmed down somewhat the buying intensified with the appetite for futures being controlled by traders still needing to roll out positions. Volumes were impressive, but many were likely knocked out of the game with a sizeable loss. The trick to trading this type of event is to continue to trade as the only way to regain losses would be to stay in the fray and trade. This is not an easy task, which is why there are times when we must stand aside and leave the action to others who are bigger, faster and have deeper pockets.

For Thursday, I would expect the US dollar to again rebound with gold sinking. Treasuries may stabilize a bit, but it doesn’t look very promising that 137 will be seen before 133 in the 30-year bond. Equity markets are likely to take their cue from treasuries and the dollar and are likely to continue to move lower. The velocity and depth will influence Friday’s triple witching expiration. Hopefully, though the moves will be somewhat more tradable.

opportunityTrading the number remains key to being able to reduce and separate the “noise” from opportunity. This takes knowing and executing a well-defined strategy and allows you to see opportunities amongst the “chaos” and by trusting the mechanics of your strategy, be able to take advantage of them.

Opportunity continues to knock on our doors. While it doesn’t come without risk, risk can be defined and more manageable. Volatility and broad moves are exactly what a day trader desires and being able to respond without questioning is a luxury many are unaware of.

Steer the course and don’t compare yourself to everyone else. You are not they and they are not you. Remember to trust and believe what makes you unique at this moment in time and in this situation and allow others to choose for themselves. Don’t be swallowed up by the chaos and false emotions swirling around. Remember it’s just a number.