15 years. See www.cbot.com for more detailedinformation on contract specifications.
4
According to a subsequent SEC investigation, the consultant started to informhis clients of the Treasury’s impending announcement at 9:28 A.M.
5
Securities and Exchange Commission. “SEC Brings Enforcement ActionsAgainst Three Individuals, Goldman Sachs, and Massachusetts Financial Services Company Related to Trading Based on Non-Public Information About theTreasury’s Decision to Cease Issuance of the 30-Year Bond.” September 4, 2003.
6
Securities and Exchange Commission. “Speech by SEC Staff: Remarks toAnnounce the Filing of Actions Related to Trading Based on Non-Public Information About the Treasury’s Decision to Cease Issuance of the 30-Year Bond.”September 4, 2003.
7
As a result of the preceding insider trades, the SEC secured settlementswhereby Peter Davis agreed to “disgorge $29, 598…[in consulting fees] receivedfrom Goldman Sachs and [a major money management firm] plus prejudgmentinterest and pay a penalty of $120,000.”…Goldman Sachs agreed “to disgorge$1,742,642 in bond trading profits and prejudgment interest, and to paya penalty of $5,000,000. In addition, Goldman Sachs [agreed] to disgorge$2,562,740 in bond futures trading profits and prejudgment interest…” TheSEC also secured an approximately $900,000 settlement with a major moneymanagement firm even though the SEC subsequently dropped the charges of
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insider trading against one of its fixed income portfolio managers. On November12, 2003, the SEC announced that John M. Youngdahl, the former Senior Economist at Goldman Sachs, agreed to pay a $240,000 penalty to settle the insidertrading charges.8
Economists refer to the set of potential future outcomes as states of the world. Acomplete market exists if there is a security for each member of the set of all possible states of the world. Of course, the sum of the probabilities for each state ofthe world would equal one.
9
Short-covering rallies are an example of an internal (to the market) trading catalyst. Internal trading catalysts are discussed in Chapters 8 and 9.
10
“Energy prices have turned volatile again, driven by the impact of productionoutages and unfavorable weather that have prompted traders to snap up oil andgas contracts ahead of this month’s OPEC meeting, which some expect couldresult in further supply reductions…” The Wall Street Journal, January 11, 2005,p. C5.
11
Richard Waters. “eBay shares fall by 11% as earnings falter.” Financial Times,January 20, 2005, page 1.
12
Maurice Allais. “Forgetfulness and Interest.” Journal of Money, Credit andBanking, Vo. 4, Issue 1, February 1972, pp. 40-73.
13
Bloomberg News at www.bloomberg.com, May 4, 2005.
14
The designation of a fast market for an unscheduled trading catalyst is invariablymade slightly late and the designation is invariably lifted late as it is lifted after thefast market ends. As a result, designated periods of fast markets do not completelycorrespond to observed periods of intense market action and price movements.
15
Andrew Balls, Richard Beales, Joanna Chung, Jeremy Grant, and Gillian Tett.“US Treasury might reissue 30-year bonds.” Financial Times May 5, 2005,page 23.
16
Steve Johnson. “Greenback makes strong gains.” Financial Times, February 4,2005, page 26.
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3TALK ISN’T CHEAP
“Silence is golden.”—Proverb
Irrational ExuberanceOn Thursday, December 5, 1996, Federal Reserve Chairman AlanGreenspan accepted the Francis Boyer Award from the AmericanEnterprise Institute and gave an after-dinner speech. The speech,“The Challenge of Central Banking in a Democratic Society,” focusedlargely on the history of monetary policy in the United States and theevolution of central banking. However, as both the guest of honor andthe dinner participants knew, anything that the Fed chairman saidwould be closely scrutinized by market participants for hints onpotential Fed monetary policy actions as well as his views on financial61
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markets. Listeners found what they were looking for when ChairmanGreenspan made a few brief remarks on the “interactions of assetmarkets and the economy” about three-quarters into his talk. To besure, the comments were cautiously stated and rhetorical questionswere raised, but the choice of words ensured that the message wasclear. Although the speech was more than 4,300 words long, only twowords are likely to be long remembered: “irrational exuberance.” Thephrase was interpreted as questioning whether the level of stockprices was too high and indicative of a financial bubble.The reaction to Greenspan’s comments was both swift and dramatic. The reaction was international in scope and also relativelyshort-lived. Although most markets in the U.S. were closed, marketsin Asia were open along with some U.S. futures markets. Not surprisingly, equity markets around the world bore the brunt of the sell-off.Greenspan’s comments echoed the belief, in some quarters, that theU.S. equity market was already in the midst of a financial bubble in1996—especially the high-tech sector. As is often the case, tradingcatalysts expected to impact U.S. financial markets often have aneven more pronounced effect on foreign markets. The reverse is nottrue for trading catalysts expected to principally impact foreign markets. U.S. markets often seemingly ignore the impact of trading catalysts on foreign markets.On Friday, December 6, the Dow opened sharply lower and wasdown, at one point, about 145 points or more than 2 percent.1 Themarket later rallied back to close only 56 points lower. The impact ofGreenspan’s comments on financial markets was short-lived.An individual who anticipated Greenspan’s comments andshorted an exchange traded fund or a portfolio of stocks that mirroredthe Dow Jones Industrial Average at 6437.10 (the level that the Dowclosed at on December 5, 1996) would have been profitable for, atmost, two weeks.2 The hapless short who kept his position openwould still be underwater in July of 2006. The Nasdaq CompositeIndex closed at 1300.12 on December 5, 1996. An individual who
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shorted an exchange traded fund or a portfolio that mirrored theNasdaq Composite Index immediately before Greenspan’s commentswould have been profitable until January 1997, then unprofitableuntil mid-March 1997, and then unprofitable after May 2, 1997. And,assuming the individual survived the multiple heart attacks thatwould have occurred when the Nasdaq Composite Index hit a high of5,132.52 on March 10, 2000, the short would have been periodicallyprofitable from July 22, 2002 to October 29, 2002. The short wouldbe underwater after that point. The lessons are simple: Timing iseverything and beware of policymakers offering investment advice.Figures 3.1 and 3.2 depict the immediate- and medium-term impactof Greenspan’s comments on the Dow Jones Industrial Average andthe Nasdaq Composite stock indices.The short-lived effect of Greenspan’s comments is seen also inthe behavior of stock index futures prices. For instance, anexamination of the (most actively traded) December 1996 S&P 500stock index futures contract time and sales price data indicates thatthe S&P 500 futures hit an intraday low of 725.50 at 9:53:17 (Easterntime) Friday morning December 6, 1996 only to rally sharply higherimmediately thereafter. On Monday, December 9, 1996, the DowJones Industrial Average closed up 82 points on no significant newserasing Friday’s losses. This is a point worth emphasizing. Largemoves in financial market prices sometimes occur in the apparentabsence of news.It is worth noting that the, albeit short-lived, immediate 2.5%decline in U.S. stock prices attributed to Mr. Greenspan’s remarksrepresented a significant loss to market participants who sold at thelower prices the remarks precipitated. Put differently, 2.5% of thecapitalized market value of U.S. equities evaporated for part of a daybut fortunately reappeared. It is not clear what policy objectiveGreenspan’s comments accomplished. Was it to encourage individuals to short the market in order to bring market prices back to“rational exuberance” levels, whatever that is?
64
7900.007800.007700.007600.007500.007400.007300.007200.007100.007000.0012/6/1996One day after Greenspan’s speech
6900.006800.006700.006600.006500.00
12/6/1996date.open 6437.10date.high 6437.10date.low 6292.87date.close 6381.95
6400.006300.006200.006100.006000.005900.0011/1/96
12/1/96
1/1/97
2/1/97
3/1/97
4/1/97
5/1/97
6/1/97
Reaction of the Dow Jones Industrial Average to Greenspan’s speech on the evening of December 5, 1996. Daily trading range of the Dow Jones IndustrialAverage from November 1, 1996 to June 30, 1997.
Greenspan speaks: irrational exuberance and the DJIA.
TRADING CATALYSTS
FIGURE 3.1
12/6/1996date.open 1275.90date.high 1293.87date.low 1259.19date.close 1287.68
1450.0012/6/1996One day after Greenspan’s speech
1400.001350.001300.001250.001200.001150.0011/1/96
12/1/96
1/1/97
2/1/97
3/1/97
4/1/97
5/1/97
6/1/97
CHAPTER 3 • TALK ISN’T CHEAP
1500.00
Reaction of the Nasdaq Composite Index to Greenspan’s speech on the evening of December 5, 1996. Daily trading range of the Nasdaq CompositeIndex from November 1, 1996 to June 30, 1997.
FIGURE 3.2
Greenspan speaks: irrational exuberance and the Nasdaq.
65
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Although the phrase “irrational exuberance” was widely reportedby the media and applied to U.S. stock prices, Greenspan’s exactcomments are largely rhetorical in nature and very cautiously stated.It is instructive to consider exactly what Greenspan said that triggered the selloff around the globe.3The December 1996 Greenspan irrational exuberance commentsare interesting because of subsequent events in the U.S. stock market, particularly in the high technology and dot.com sectors. Themagnitude and duration of the impact of Greenspan’s remarks aresimilar to the financial market impact of other remarks by policymakers. It should be also be noted that despite Greenspan’s “irrational exuberance” remarks and subsequent occasional commentsthat the stock market might be in a bubble, the Federal Reserve pursued a monetary policy over the subsequent few years that accommodated what some observers viewed, at the time, as excessive growth inU.S. stock prices. For instance, the Federal Reserve chose not toraise stock margin requirements during this time period, whichwould have hindered the ability of individuals to place levered betson the stock market.
Comments by Politicians andPolicymakers as Trading CatalystsThe old saying that “talk is cheap” need not apply to the comments ofpoliticians and policymakers. When the comments of politicians andpolicymakers impact financial markets, talk may not be cheap for thetraders and investors on the wrong side of the market whose positionsare adversely affected. The financial market impact of such comments may be substantial as the preceding example detailing the market’s reaction to Greenspan’s irrational exuberance commentsillustrate. Unfortunately, ordinary investors often foot the bill for illadvised comments by politicians and policymakers in terms of lower
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prices for the assets they hold and more volatile financial markets thatsuch comments often create.This chapter details the impact that the comments of politiciansand policymakers sometimes have on financial market prices. Suchcomments can be decomposed into those that are intended to impactfinancial markets and those that unintentionally do so. Comments canalso be categorized into those that impact financial markets asintended, those that do so perversely, and those that exert no effect.Several examples are provided to illustrate the various impacts thatpast comments have exerted on financial market prices.When a policymaker speaks, market participants have to determine whether the comments contain potentially market-movingnews—that is, market participants must ascertain whether the comments of policymakers signal a change in policy, an impending policyaction, or are inadvertent. Given that policymakers know that theircomments can roil financial market prices, the prevailing bias is to treatmost policymaker comments as intentional. These comments impactfinancial markets and often create short-term trading opportunities.Intentional comments are viewed as signals to market participants about the preferred level of commodity or security prices,interest, or exchange rates by policymakers. However, it is not thewords that pack the punch to financial markets; it is the implicitthreat of a policy action by one or more large players such as the central bank or the central bank in concert with other central banks.Traders fear that a policymaker can cause momentary large gapsbetween supply and demand and influence prices in the process. Aclassic example in this regard is intervention in the foreign exchangemarket to prop up a weak currency or weaken a strong currency inorder to achieve some policy objective.Although much of the power of policymaker comments derivesfrom the implicit threat of a policy action, savvy policymakers haveincreasingly attempted to increase their influence by piggy-backing
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on market trends and internal market forces. One of the ways thatpolicymakers can maximize their influence is by carefully timing theirannouncements and market operations. For example, a central bankmay make an announcement on exchange rates during a period whenmajor foreign markets are closed. Similarly, an announcement madeduring a pre-holiday lull in trading for the domestic market may havemore impact than the same announcement made during regular trading hours. Market conditions may also play a role. Given the popularity of technical analysis among many traders, announcements madewhen exchange rates are near key resistance or support points maytrigger a larger reaction than the announcements otherwise woulddue to positive feedback trading (i.e., trading that feeds on itself).The speed, magnitude, and duration of pronouncements vary. Inmost cases, the market is very quick to respond and the markets movesharply. As noted previously, the magnitude of the response maydepend upon market conditions and sentiment bias. For instance, ifthe market is currently trending in one direction, the announcementmay accelerate the move. Any policy action that triggers positivefeedback trading can have a greater impact on market prices. Knowledge of various feedback effects may affect a policymaker’s choice ofinstrument to implement the policy action. For instance, the Bank ofJapan considered using options a few years back to maximize its influence because it knew that sellers of options would dynamically ordelta hedge their positions by taking an appropriate fractional corresponding position in the cash market.4 A sharp price move thatincreases the value of the options increases the absolute value of deltaand forces the option hedger to increase his hedge position andthereby exacerbate the price move.One special category of pronouncements by policymakers andpoliticians are broken promises. These utterances attempt to reassurethe public that the status quo will remain so (e.g., that a currency willnot be devalued). Often, market prices increase slightly after thesepronouncements. These public reassurances are followed in short
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order by a decision announcing the opposite of what was recentlypromised. Unfortunately, broken promises of this nature are distressingly frequent. However, such comments may assist traders by serving as a confirmatory signal that the current policy is no longertenable and will be changed soon. To be sure, such pronouncementsinvariably occur during a period of tremendous pressure in financialmarkets. Put differently, market participants are voting with theirwallets, and the current politicians and policymakers in power are losing. Nevertheless, the broken promises exert substantial losses onthose unable to get out before the change.
Greenspan Speaks and Markets MoveThere are numerous examples where the comments of the chairmanof the Federal Reserve System have impacted market prices. Indeed,this chapter opens with an example of the impact of former FedChairman Alan Greenspan’s comments on financial markets. Tenmonths after he uttered the words “irrational exuberance” in an afterdinner speech in Washington, Greenspan testified before the HouseBudget Committee on Wednesday, October 8, 1997. During thecourse of his remarks on the economy, Greenspan made the followingcomments about financial markets and the real economy:…The long-term outlook for the American economy presentsus with, perhaps, even greater uncertainties. There can be little doubt that the American economy in the last several yearshas performed far better than the history of business expansions would have led us to expect. Labor markets have tightened considerably without inflation emerging as it has in thepast. Encouraged by these results, financial markets seem tohave priced in an optimistic outlook, characterized by a significant reduction in risk and an increasingly benevolentinflation process. [Emphasis added]
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Thus, there would seem to be emerging constraints on potential labor input. If the recent 2 million plus annual pace of jobcreation were to continue, the pressures on wages and othercosts of hiring large numbers of such individuals could escalate more rapidly…Thus, the performance of the labor markets this year suggests that the economy has been on anunsustainable track… [Emphasis added]5The market’s reaction to Greenspan’s testimony was immediateand negative. The prices of both stocks and U.S. Treasury bonds fell.The Dow Jones Industrial Average fell almost 1 percent, whereas thelong bond was down 1 and 21/32 points.6 Market participants whowere long stocks or Treasury bonds suffered losses both during andafter Greenspan’s testimony. Although there was an initial overreaction to Greenspan’s comments, the markets closed lower for the day.Unlike the market’s larger reaction to Greenspan’s irrational exuberance comments in December 1996, the stock and bond markets didnot immediately rebound the next day and remained below wherethey stood before Greenspan testified for a number of days.
Other Voices at the FedAlthough attention is usually focused on the comments of the Fedchairman, other individuals at the Federal Reserve can impact financial market prices through their comments. This applies not only tothe vice chairman and other members of the Federal Reserve Boardof Governors, but also to the presidents of the twelve individual Federal Reserve district banks that comprise the Federal ReserveSystem. One consequence is that traders must monitor the commentsof a number of individuals at the Federal Reserve System.Sometimes, the remarks of a Federal Reserve president can exerta significant impact on market prices. For instance, on Wednesday,
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June 1, 2005, Richard W. Fisher, the president of the Federal Reservedistrict bank of Dallas, Texas indicated that he thought that the Federal Reserve might stop raising short-term interest rates. Treasurynote and bond prices rallied sharply in response to the remark withyields on the 10-year U.S. Treasury note falling 11 basis points.7 TheFed typically lowers or raises short-term interest rates in a series ofchanges. The article also notes that Mr. Fisher’s comments appear todiverge from those of other Fed officials.
The Asian Financial CrisisThe Asian Financial Crisis of 1997 and 1998 is an example of how acatalyst-induced price change in one market can become itself atrading catalyst for other markets. There are also several illustrativeexamples of how ill-advised comments by policymakers and politicians during the Asian Financial Crisis adversely impacted marketprices. To better appreciate the impact of the comments, it is important to understand the origins and evolution of the crisis.The devaluation of the Thai baht by the Bank of Thailand on July2, 1997 is widely regarded as the beginning of the Asian FinancialCrisis. In fact, the Asian Financial Crisis began well before then. Theabsence of well-developed local currency fixed income markets inThailand and in many other parts of Asia meant that firms had to relyon local banks for borrowing short-term debt or issue longer-termforeign currency (principally dollar) denominated debt. Excessivespeculation in property and stocks was accommodated by banks. Theresulting bad loans weakened the banking sector. It was not just aThai problem. The crisis had deep roots across the region. This isimportant to understand when one considers how the crisis seeminglyspread from Thailand to other countries in the region. It also illustrates how ill-advised comments from politicians and policymakersduring a crisis can have perverse results.
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Problems in Thailand had arisen in 1995 when the stockmarket—as measured by the Stock Exchange of Thailand (SET)index—started to decline. Margin rules that required investors whobought on margin to sell if the stock was down by 15% or more fromthe purchase price exacerbated the decline and led to ill-advised government policies designed to support the market. Problems started tosurface across the region in early 1997. For instance, Hanbo Steel, amajor South Korean steel company, went bankrupt with $6 billion ofdebt in January 1997. This was followed by the failure of SammiSteel, another South Korean steel producer, in March of 1997.Malaysia acted to rein in excessive speculation by restricting loans forstocks and property at the end of March 1997. An early March 1997promise by the Thai government to buy almost $4 billion of bad property debt from financial firms made the situation worse when theaction was later abandoned.
Broken PromisesJust like the onset of the Asian Financial Crisis was preceded by problems, the devaluation of the Thai baht was preceded by waves ofspeculative selling of the currency. One such episode occurred duringMay 14 and 15. This speculative attack prompted intervention by theBank of Thailand to defend the baht. The Monetary Authority ofSingapore joined in this intervention. Perhaps the surest sign thatdevaluation was imminent was the promise by the prime minister ofThailand on June 30, 1997 that the baht would not be devalued.Shortly after his address to the nation, the Thai baht stood at 25.15.On July 1, 1997, the Thai baht had improved to 24.52 per dollar bynoon during New York trading hours.On July 2, 1997, the Bank of Thailand instituted a managedfloat—that is, let the baht float within a given range. The managedfloat resulted in an almost immediate 20% devaluation against theU.S. dollar; it now took 30.18 bahts to buy one U.S. dollar. The Thai
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baht appeared to stabilize following the devaluation hovering around29 baht to the U.S. dollar for several days. However, the devaluationof the Thai baht quickly put other Asian currencies under tremendous selling pressure, which prompted significant central bankintervention—that is, the devaluation of the Thai baht became a trading catalyst for other currencies in Asia that traders rushed to sell.These include the Malaysian ringgit, the Indonesian rupiah, thePhilippine peso, and the Hong Kong dollar. The spread of the sellingto other currencies is known as contagion.The breadth and depth of the selling of the currencies led to further devaluations and, in some cases, triggered an end to central bankinterventions. For instance, the Malaysian ringgit stood at approximately 2.52 to the U.S. dollar prior to the devaluation of the Thaibaht on July 2 and improved to about 2.50 ringgit to the dollar aftermassive central bank intervention on July 8. The intervention seemedto work as the ringgit improved to 2.489 on July 10. However, theimprovement apparently came at a substantial cost as the Malaysiancentral bank, Bank Negara, decided to stop intervening to defend theringgit on July 14. The Monetary Authority of Singapore devalued theSingaporean dollar slightly on July 17 in a bid to stem the decline.The central bank of Indonesia widened the bands by which therupiah could fluctuate to 12% from 8% on July 11. Less widely appreciated at the time was the tremendous pressure the Hong Kong Monetary Authority (HKMA)—the de facto central bank of the HongKong Special Administrative Region—was under to devalue theHong Kong dollar by eliminating the currency board system, whichpegged the Hong Kong dollar to the U.S. dollar. Speculative selling ofthe Hong Kong dollar also came indirectly in the form of foreign selling of Hong Kong shares, which the HKMA quelled by intervening inthe equity and equity index futures markets. This episode is discussed in more detail later in the book.From a trading perspective, central bank intervention to defend acurrency that is perceived as weak often creates the opportunity for
74
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one-sided bets—that is, a trader who shorts a troubled currency mayface relatively small losses if a central bank intervenes to maintain afixed exchange rate but obtain large gains if the central bank does notintervene (or the intervention is not effective) and the currencybreaks to a new level. The sale of a currency necessarily entails thesimultaneous purchase of another one. A central bank may soonexhaust its foreign exchange reserves as it attempts to prop up its currency. The odds of a readjustment in exchange rates increases as acentral bank’s foreign exchange reserves dwindle. This can increasespeculative pressure on the currency. It should be pointed out thatcentral bank intervention to protect a given exchange rate is tantamount to speculation.8
Speculation or Fundamentals?Not surprisingly, the charged atmosphere led some policymakers andpoliticians to accuse external speculators of masterminding thedecline in exchange rates and creating the Asian Financial Crisis. Onepolitician to levy such a charge was Malaysian Prime Minister Dr.Mahathir Mohamad.On Thursday, July 24, 1997, Prime Minister Mahathir Mohamadblamed rogue speculators for the currency depreciation.9 At the timeof Dr. Mahatir’s July 24 accusation, the ringgit had fallen about 5% tothe U.S. dollar since the crisis began on July 2, 1997. The marketlargely ignored the prime minister’s comments. The ringgit tradedlower and broke through the 2.65 level before regaining somestrength before the prime minister spoke.10 Although the commentdid not trigger a significant market reaction, it was yet another comment that, taken with other ones, may have helped to undermine theconfidence of market participants in the ability of the Malaysian government to deal effectively with the crisis.On Saturday, July 26, 1997, the Malaysian prime minister elaborated on his earlier comments on the cause of the currency crisis anddirectly blamed hedge fund manager George Soros.11 He also
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demanded that currency trading be regulated or outlawed. Thebizarre nature of the comments was made worse by the apparentanti-Semitism implicit in the accusations against George Soros. Fortunately for the Malaysian people, financial markets were closed onSaturday.The row between Prime Minister Mahathir and George Sorossoon degenerated with Dr. Mahathir calling Mr. Soros a “moron” andMr. Soros calling Dr. Mahathir a “menace to his own people.”12 At alater date, the prime minister elaborated on the supposed reasonbehind Mr. Soros’ alleged currency speculation—namely to punishAssociation of Southeast Asia Nations for admitting Burma into itsmembership.13
A Trading Pattern EmergesA period of relative stability in exchange rates soon followed with theringgit drifting gradually lower against the dollar during the month ofAugust with an occasional spike. One sharp downward move on Friday, August 8, 1997 was attributed to Prime Minister Mahathir’s comments on the appropriateness of the level of the ringgit and whetherthe central bank would intervene to support the ringgit. The market’sreaction is captured in the following report by Reuters on Monday,August 11, 1997.The ringgit remained weak against the dollar in early Asiantrading after plunging 500 points late on Friday, dealers said.The selloff was triggered by Malaysian Prime MinisterMahathir Mohamad’s comments late on Friday that he washappy with the level of ringgit, despite the local unit’s sharprecent falls…Mahathir also said that the authorities wouldnot intervene to defend the ringgit. Bank Negara [Malaysia’scentral bank], however, was in the market earlier on Friday,selling dollar/ringgit around 2.6510, dealers said. Dealers saidthin volumes and wide [bid/ask] spread would continue toexaggerate currency movements.14
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The preceding excerpt illustrates how currency market participants started to view comments by the prime minister as a significanttrading catalyst. This invariably set the stage for other comments toexert an impact on exchange rates. The excerpt also illustrates howthe credibility of politicians and policymakers is undermined whenmarket participants observe governmental actions (e.g., central bankintervention to support the ringgit) that openly contradict statedpolicy. Finally, the excerpt illustrates how market conditions—thinvolumes and wide [bid/ask] spread—can increase the size of the pricereactions.15
Other Voices Impact the FX MarketOn Wednesday, September 24, 1997, Deutsche Bundesbank President Hans Tietmeyer’s remark that a falling Deutsche mark was notin Germany’