Trading A Random Number Generator

 |  Includes: DIA, QQQ, SPY
by: Michael Ashton

Surely Bernanke is right, and all of this crazy price action is merely discounting rational outlooks. Wednesday, the Chairman told Congress that "the fact that interest rates have gone up a bit is actually indicative of a stronger economy."

Really? Do we really have any idea what it is indicative of, when the price being discovered isn't a free market price? Where the heck did he learn economics, from correspondence school? You may as well say that since the price of bread in the former Soviet Union was very stable, it indicated that markets were in balance. Well, either that or it indicated that the State thought the price ought to be steady.

To be sure, the economic data over the last couple of days has been terrific (compared, as always, to what we've become accustomed. On Tuesday, New Home Sales hit the highest level since the summer of 2008, at 437k when economists were looking for 380k. Consumer Confidence printed 69.6, a huge jump from 58.4 in January and a well above the 62.0 expected (yes, this is strange with higher gasoline prices and higher taxes, but it is still below November's level so perhaps it just reflects relief that Congress is in gridlock - interestingly, the "Jobs Hard to Get" subindex rose).

On Wednesday, Durable Goods ex-Transportation orders rose 1.9%, easily beating the +0.2% consensus. And Italy managed to sell debt, although one is never sure these days if the buyers are buying it because they believe in Italy, or because they're banks who get good accounting treatment.

So life is good, and stocks rose 1.3%, erasing what was left of Monday's downdraft.

And, obviously, because growth is so good Gasoline was crushed, with its worst 1-day drop since November. Industrial metals also declined. But inflation breakevens and inflation swaps, despite that, widened.

Bonds sold off slightly, although for most of the day - with the immediate Italy crisis already fading and the economy evidently feeling better - they were higher.

The dollar fell, and precious metals fell as well.

But clearly, this all makes sense to Bernanke, who is at peace with the world at the moment. There are no signs of anything wrong to the Chairman.

Although a long period of low rates could encourage excessive risk-taking, and continued close attention to such developments is certainly warranted, to this point we do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more-rapid job creation.

But you know, here's the REAL problem - why does he, or any of the smart people on the FRB, or any of the smart people at the Fed as a whole, get to decide how to "weigh the benefits of economic recovery" compared to the "potential costs of increased risk-taking in some financial markets?" This is something that the market is supposed to do. Right, Comrade?

It is one thing to believe that the government or Federal Reserve should step in when there is a market failure. It was arguably (although I am one who would argue against it) the right thing to do for the Fed to guarantee commercial paper issuance during the crisis so that businesses could continue to fund themselves in the dysfunctional, poorly-planned, but nevertheless critical-at-that-moment way they had become accustomed to. But the Fed simply shouldn't be in the business of weighing "potential costs of increased risk-taking" versus the "benefits of…more-rapid job creation."

We are all investors and traders here. What is the first thing you learn as a trader? The market is bigger than you are. Not that the market is always right - far from it - but if you lose to the market then you need to ask whether the millions of other traders collectively know something you don't. And the point is writ even larger when you're talking about the economy as a whole. If the bread is too expensive, then the baker won't be able to sell all of it and he'll have to lower his price tomorrow. There is no way that the Central Committee can set the price of bread more intelligently than can the market. And that goes double for the price of risk.

So, while we're talking about Fed overreaching, take a moment to read this one-page summary by Brian Wesbury about how the Fed will make excuses about inflation when inflation begins. People often ask me, "won't the Fed simply start to tighten once inflation makes them uncomfortable," and the discussion then revolves around how long it will take the Fed, once they move, to have an impact on the inflation dynamic. But Wesbury gets to the behavioral dynamic of the Fed and proceeds to detail - I think with absolute plausibility - how the Fed will excuse rises in inflation once it heads higher. In sequence, the excuses will be:

  1. Higher inflation is due to commodities, and core inflation remains tame.
  2. Higher core inflation due to housing is just due to housing prices bouncing back to normal, and that's temporary.
  3. It's not actual inflation that matters, but what the Fed projects it to be.
  4. It's okay for inflation to run a little above 2% for a while because it was under that level for so long.
  5. Increasing price pressures are due to something temporary like a weaker dollar or a temporary increase in money velocity or the multiplier.
  6. Well, 3-4% inflation isn't that bad for the economy, anyway.

Wesbury gives a little more color about how the transition from excuse to excuse will happen so smoothly - it's worth it reading the short summary in his own prose.

When everything from the price of 10-year notes to the price of risk as a whole is being controlled by the Fed, any kind of forecasting or trading is almost a fool's game. It's like trading a random number generator because deviations from fair value are not followed, necessarily, by an eventual return to fair value. I believe that in this environment, it is as important as ever to focus not on reaching for better returns, but in nailing down your risks as best as you can (especially when the price of such hedges is low, ironically for the same reason that the price of risky strategies is low). Right now, I believe that one of the biggest risks is that of an inflationary outcome. I hope each person out there is thinking carefully about how well his or her portfolio is protected against such an outcome, because there will be no excuses when it happens…except from the Fed.