How to Trade Using Game Theory

Includes: GS, SPY, TBT
by: Negative Carry

Given the recent upsurge in government intervention in the economy (and financial markets), as well as the collusion between banks and government in response to the financial crisis (AIG CDS undwinds, NY Fed's Goldman shares ahead of BHC announcement, etc. etc.), following "smart money" has now come to mean following those in-the-know of future government actions, or at least those with high predictability or involvement.

Back in June 2008, the Treasury's Exchange Stabilization Fund's Euro reserves dropped dramatically, to the tune of about 6 billion Euros, as reported by the Treasury's weekly releases on international reserve positions. This large supply of Euros presumably was used to finance demand for dollar derivatives, allowing the Treasury to pull a large of USD out of the market. Indeed, the ESF's actions correlate very well with the collapse of the commodity bubble and the beginning of the Dollar bull, as is evident in the image below, courtesy of Now and Futures:

Chart of ESF balances vs Euro purchasing power

The ESF's actions, by pulling liquidity, also could have been the "push" catalyst for a number of credit events in the following months, which further increased demand for USD as entities rushed to deleverage and pay off dollar-denominated debt. The Fed's extension of dollar liquidity swaps drawn on by foreign entities also helped the Dollar.

Since, the Fed's liquidity swaps have been on the decline, pushing the Dollar back down, and allowing currency depreciation to have the reciprocal effect on equities.

Mean reversion, of course, is an inevitable law of nature. The exogenous catalysts that set off the positive-feedback systems that unwind years of imbalances vary, however, and the recent government actions have become the new norm for this.

The Treasury and Fed are now at a crossroads. The Dollar Index is back to 2007-2008 levels, as the liquidity-driven rally in equities has been met with pervasive USD selling. Crude oil is back to $70/bbl and further depreciation of the Dollar could push oil back to triple digits, especially if the Dollar Index breaks its important support around 72. $80/bbl+ oil cannot be at the forefront of any sustainable economic recovery.

On top of that, Treasuries have tanked since January's highs and sold off massively since QE was initiated back in March. 30-yr Tsy rates have more than doubled off their lows in less than nine months, and the 6% mortgage is back. 6-7%+ mortgage rates are much too expensive to allow any economic recovery, and Bernanke's quest for 4.5% mortgage rates at the beginning of QE clearly cannot be reached if current trends sustain.

The fact is, the Fed and Treasury both need a large, swift suppression of rates to reflate credit to catalyze nominal recovery and to be able to roll over the enormous national debt and keep spending.

Just like last summer, when the Dollar was depreciating so quickly and crude had reached levels of "energy crisis," we are now at an important crossroads for the USD. Back then, interest rate hikes to defend the USD were being considered. Now, clearly, that is not an option whatsoever. In fact, rates are much too high as it is and the Fed Funds rate has reached its nominal price floor of zero.

The only option for the Fed/Treasury is to somehow spur organic demand for USD and Tsys. Nothing like a crash in equities and commodities to do that.

And if the Fed and Treasury are incentivized for a risk asset crash to provide inflows into the USD/Tsy "safe haven" trade, why bet against it?

As always, the question is where does this market top? There is ample evidence that this rally is a "works-until-it-doesn't," positive feedback, liquidity-driven, unsustainable market event; however, timing the top and positioning yourself for the selloff is not an easy task.

Technical chart analysis to find important resistance levels where sufficient supply in volume may be offered to stop the rally in its tracks is my preferred method of timing market moves. However, in the context of the Fed's/Treasury's actions, a look at the Fed's POMO schedule may provide some hints as to when the liquidity driving this rally dries up.

Since QE wasn't extended, the last POMO date scheduled as of now is in early September. With rates this high, equities in a rising wedge rallying on no volume, the USD almost back to 2008 lows and commodities having outpaced equities since their bottom, a massive decline in equities and commodities starting in August-Septemeber seems to be the play. An October crash scenario repeat of last year is far from being out of the question. Meanwhile, bonds should surge, rates should tank, the USD and JPY should fly, and the EUR, AUD, GBP, and CAD should drop like a rock.

The variable here is how gold will perform. The United States' deficit spending and debt monetization has caused bondholders to sell duration and leave Dollar-denominated debt and the USD in mass waves. As the safe haven trade makes an encore this fall and winter, it will be interesting to see the proportion of equity and commodity outflows that go into precious metals instead of USD and Tsys.

In my opinion, we have reached a disconnect between "smart" and "dumb" money actions, as far as safe haven perception. Obviously, the deleveraging wave this fall will provide massive demand for USD, but the more relevant demand in context of this article is for risk asset outflows for safety. The money leaving stocks for bonds is feeding a bubble that can only result in the ultimate Black Swan, that of a bond implosion.

Though game theory/MAD would never allow for a hyperinflationary, triple-digit interest rate scenario in the United States (though America's fiscal and monetary policies may warrant such an occurrence in a vacuum), the mass influx into Tsys offers a frightening picture of herds moving into essentially toxic assets. Once more debt starts being monetized, excess reserves are unsequestered, price inflation creeps in, and debt inflation wreaks havoc on real interest payments, the resulting picture is of a crowded trade gone terribly wrong.

It is then that precious metals may get bubbly and today's "smart money" buyers may become sellers.

But at present, the picture remains deflationary and deleveraging dominates. Rates are too high for continued recovery, the USD is falling off a cliff, there is no revenue growth or CapEx improvement, and unemployment is rising. The equity and commodity markets are pricing in absurd levels of growth, and the demand is not being offered by perception of economic growth, but rather by Fed-gifted excess liquidity that is inherently buy-biased.

So if you were the Fed, given current conditions, what would you want? Would you want rates to keep rising and the credit reflation to fail? Or would you want rates to go back down, and leave the taxpayer holding the bag as the retail investor who bought the record levels of debt and equity issued into this rally? Would you want rates to sustain their current trend and China and Japan to offer a mass exodus from bonds, preventing any attempt at debt rollover to continue deficit spending? Or would you want to bring creditor nations back into panic mode, buying your bonds and leaving them the bagholder for your toxic securities as you monetize your way out of debt?

Excess liquidity is a funny thing. It is nothing but pulled-forward wealth looking for a present-day home. The ballooning of the Fed's balance sheet has been sequestered as excess reserves thus far, most likely actually ending up as proprietary trading buying power for banks. But when these excess reserves come flooding into the economy, expect the next sustainable bull market in commodities to begin, through inflation.

Right now, the excess liquidity is chasing equity beta; it is momentum-chasing, positive-feedback, and causing a rally anything but durable. When this liquidity reaches the real economy, the lending and spending level, is when the pulled-forward demand represented by the liquidity causes nominal economic growth to allow corporate revenue and earnings growth to support an equity bull market. When will that happen? When the excess reserves are unsequestered, when this chart shows a new uptrend:

YoY Growth in Commercial Bank Credit

Until then, the Fed's mass printing will only be used by bank prop desks to chase high-beta equities and keep a constant bid in the market... Until the liquidity dries up, the stock market plunges, Treasuries rally, and the Fed once again has the political capital and further room in the USD to fall to print more. And eventually flood the economy with the excess reserves all the printed money is going into. When this happens, expect the next home for excess liquidity (bubble) to manifest itself: gold.

Disclosure: long SPY calls (hedge), short GS