OlsenBlog

Today, there is a divide between the optimism of the public and the concerns of practitioners with in-depth market knowledge. Who will be right?

What does the theory of high frequency finance tell us?

Central banks and governments have the clout to skew market prices for extended periods of time. They are successfully doing this in response to the economic crisis by providing liquidity to lower short-term interest rates and by buying long dated debt to lower long-term interest rates. They succeeded in stopping the meltdown of the financial markets, but they cannot continue their skewing strategy indefinitely. They need to be aware that their actions will give rise to a rebound, which has the effect that interest rates will be higher than normal. Financial markets tend towards a dynamic equilibrium, where overshoots in one direction will ultimately be balanced out by overshoots in the other direction.

Governments have also increased their budget deficits to dangerously high levels, such as 12 percent of GDP for the US. Such high levels of deficit are precarious because they are not sustainable in the long run. Debt grows too rapidly but what can be even more dangerous is if the economy does not rebound decisively; the overall economy can be hit by a double whammy effect of lower government expenditure plus rising interest rates due to a deterioration of the economic outlook. So the current situation is high risk.

My big fear for 2010 is the ability of governments to get funding. It only takes a failed US treasury auction to highlight the risk on the interest rate front. Investors will become gun shy and interest rates will start to rise rapidly and costs for servicing debt will increase. This will dash hopes of a rosy future and will change the public sentiment from serene confidence to fear and pessimism.

What does this mean for us as investors, business people or members of government?

Stock markets: the rally of the stock markets of 2009 happened because nobody foresaw the rise of equity prices and the people shorting the stock market got squeezed. It was only late in the game that investors started to pile into the stock market. This is a dangerous situation as the sentiment can change at any time and then investors will sell in panic. I therefore, recommend reducing exposure to the stock market. Rallies that are caused by short squeezes are treacherous; they can last far longer than expected but can equally and abruptly end with a bang.

Fixed income markets: The massive lowering of interest rates has offered a unique environment to earn money in the bond market. According to our analysis, interest rates are far below their natural equilibrium. At some stage the day of reckoning will come. I therefore recommend lowering exposure in the fixed income markets and in particular, would shun long-term bonds. I expect that the credit rating of governments will become an increasingly important issue, so investors need to be alert to the changes of rating of government entities.

Currencies: The major currencies will be under pressure, because the ability of governments to fund themselves will be questioned. The challenges of big countries are so much bigger than those of governments of smaller countries, which are in closer contact with their people and will find it easier to achieve consensus to tackle critical issues. I clearly favor an investment in smaller currencies, which will profit from the higher degree of consensus of their people.

For full disclosure: At Olsen, we follow a systematic investment strategy with a counter-trend strategy that provides market liquidity. Our investors are rewarded because we trade the long 1600 percent coastline of every exchange rate to provide liquidity and price stability and do not bet on the next big trend.

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December 29th, 2009 | Market, News | RSS feed