Are Fundamentals Really Driving the Currency Markets?

Plus ca change, plus c'est la meme chose. Given the ongoing travails of the financials, particularly the Agencies, it's tempting to simply re-issue this post from early last month. However, there are a few fresh developments in the never-ending saga of financial institution distress that merit comment.

Most notable of these is the Fed's decision to import monetary policy from China, which in some ways is a welcome change from standard operating procedure. Although the PBOC has hitched its wagon to the Federal Reserve in terms of setting the level of the Chinese currency and interest rates, regular China watchers will know that credit there is allocated largely by administrative diktat rather than supply and demand.

Apparently, the Fed has adopted the same model, at least if the Wall Street Journal is to be believed. That the Fed has given Credit Suisse (CS) a "nudge, nudge, wink wink" hint that it should continue to trade with Lehman (LEH) isn't particularly surprising, and in many ways is justified as a pragmatic measure to avoid systemic risk.

But it seems fairly obvious that some well-known financial institutions that currently exist will, at some point in the not too distant future, cease to do so, at least in their current guise. One would hope that there are more comprehensive policy prescriptions in place than "gee, it would really be swell if you didn't pull their line" moral suasion should such an outcome arise. On current form, however, there don't appear to be any.

In that vein, your humble scribe is pleased to offer the "Macro Man Plan to Ensure That People Keep Trading With Institution X". While some of his suggestions may seem outlandish, please bear in mind that his recent modest proposal to reduce the US government funding gap appears to have resonated with the Governor of New York.

At the heart of the Macro Man Plan is that financial institutions adopt the incentive programs offered by other service industries such as retailers and minor league baseball. To encourage ongoing business relationships, banks and agencies (and maybe even the odd hedge fund or two) should offer the following suite of incentives to potential counterparties:

1) Loyalty cards. In a scheme familiar to supermarket shoppers around the world, counterparties would be issued with loyalty cards and accrue bonus points for each transaction that they conduct. Once certain thresholds are reached, these could be redeemed for goods at the bank's affiliate partners, such as Amazon, Tesco, Wal-Mart, etc. In exchange, these latter firms would receive free investment banking advice.

2) Buy one, get one free! Lehman, Merrill (MER), Fannie (FNM) and Freddie (FRE): maybe you could sell more (or, more to the point, any) of your RMBS portfolio if you offered potential counterparties a "buy one, get one free" deal. Think about it...

3) Free oil! For every ticket that generates more than $250k worth of VAR, offer counterparties one free barrel of oil. When your £170,000 sports car only gets 11 mpg, every little helps...

4) A free T-shirt with every ticket! Every time you trade with bank X, they send you a free T-shirt! In fairness, this would really only appeal to very junior traders fresh out of university, but hey; we at Macro Man Industries want to cover every demographic.

5) 1000 free shares of stock with every trade! Every time you trade with Bank X, they'll give you 1000 shares of their stock absolutely free! You win by getting free stock, they win because the infinitesimal revenue that they book from each trade will labeled as "new capital" on the balance sheet, and they can announce to the world that they have raised yet more capital from eager investors. Of course, if the stock price goes down, then you incur a mark-to-market loss. On second thought, maybe they should offer free puts on 1000 shares with every ticket...

Elsewhere, a brief follow-up to yesterday's post. One of the things that Macro Man does in his real job is to run indicators that attempt to determine which fundamental themes are driving currencies at any point in time (don't ask, he's not going to be more specific than that). And what's interesting about the recent dollar move is that none of the fundamental themes that traditionally drive exchange rates has been in play during this dollar move.

This morning he quantified this into a combined "thematic strength" indicator, wherein a high reading indicates that currency markets are trading very thematically, and a low reading suggests that so-called fundamentals are not driving FX.

And what we can observe is that this is the least thematic market since the summer of 2003. It appears to have been micro (idiosyncratic decisions and/or momentum), rather than macro, that has driven the recent dollar rally. So if you've struggled to understand why the buck is up, don't worry; it's taken a lot of people by surprise.

Comments

[OldLimey:]

Re ideas 1-5: how about adding a sixth - hedge funds drop 2 and 20 to 1 and 10. (Limited period offer, of course, just while stocks - or should that be Funds - last.)

Re the USD: it certainly didn't feel like a move based on fundamentals, but it's always good to have feelings backed by some high-powered (if proprietary) technical wizadry. Where did I put those kiwis...

2008 Aug 22 11:25 AM