anley Druckenmiller once said that George “Soros has taught me that when youhave tremendous conviction in a trade to go for the jugular.” Jack D. SchwagerThe New Market Wizards: Conversations with America’s Top Traders, New York:HarperBusiness, 1992, p. 208.
7PERIODIC ECONOMICREPORTS
“One dog barks at nothing, ten thousand dogs assertits truth.”—Japanese proverb
The Trade Deficit Sparks a BondMarket RoutOn Tuesday morning, April 14, 1987, fixed income, currency, andcommodity traders anxiously awaited the release of the latest measure of America’s perennial trade deficit with much of the world. Theday before, the dollar, Treasury bonds, and U.S. stocks fell sharply,and precious metals rose in response to a late-day rumor that themerchandise trade deficit for February 1987 would be $18 billion—substantially more than the $13.3 billion consensus forecast. Recent193
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price action suggested that bonds and the dollar were in a bear market, whereas stocks remained in a bull market. The question manymarket participants pondered was whether the bull market in equities would turn bearish anytime soon, and if so, what might trigger it.At 8:30 A.M. that morning, the Department of Commercereleased the merchandise trade balance report for February 1987.The department reported a merchandise trade deficit of $15.06 billion for February, significantly greater (in absolute value terms) thanthe consensus forecast. In addition, the department revised the previously reported January 1987 trade deficit upward to $12.27 billion.1The financial market reaction was swift and negative. The dollar fell,stocks fell, bonds fell, and gold rose. The apparent operative tradingthesis among market participants was that a larger-than-expectedmerchandise trade deficit would cause the dollar to fall and interestrates to rise because of fear of higher inflation (imported goods wouldcost more) and less demand by foreign (particularly Japanese)investors for dollar-denominated U.S. Treasury securities. The higherinterest rates, in turn, would precipitate a decline in stock prices asthe required return or discount rate increased. Some of the market’sreaction to the report and the economic relationships traders perceived at the time is described in the following excerpt from an articleby Tom Herman and Alexandra Peers in The Wall Street Journal onApril 15, 1987.…Early in the day, actively traded U.S. Treasury bondsplunged in frenzied trading after the Commerce Departmentreported an unexpected surge in the nation’s merchandisetrade deficit for February. Also weighing heavily on the bondmarkets was another sharp increase in the price of gold,which is watched closely as an indicator of inflation.Nevertheless, Treasury bond prices later rebounded to finishthe day with only small declines. After being down nearly twopoints early yesterday morning, 30-year Treasury issues
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wound up with declines of about 1/4 point, or $2.50 for each$1,000 face amount. That brought the total drop since March26 to about nine points…The Commerce Department’s trade report early yesterdayjolted the bond markets even though there had been widespread rumors Monday afternoon that the report would showa huge $18 billion deficit…The trade figures helped drivedown the dollar in the currency markets.2The article also indicates that the most actively traded 10-yearTreasury note actually closed slightly up for day as the yield fell byone basis point to close at 8.19%. The Dow Jones Industrial Averageclosed down over 34 points or about 1.5% in the second-busiest trading session ever, whereas spot month (April delivery) gold futuresclosed up $13.80 per troy ounce on the Commodity Exchange.3 Bothmoves were attributed to the trade balance report.Figure 7.1 depicts the reaction of the 30-year, or long, Treasurybond to the report. The bond market reaction to the reported tradedeficit for February 1987 underscores both the importance attachedto the news in the merchandise trade balance report and the transientnature of the influence of economic reports. Bonds moved twopoints (or $20 on a thousand-dollar bond) yet recovered most of theearly losses by the end of the day. The 10-year Treasury note reversedcourse and ended the day modestly higher. Moreover, the magnitudeof the bond market’s reaction—down 2 points initially—was surprising given that the rumor the day before that the February 1987 tradedeficit would be $18 billion precipitated a 1 3/4 point slump in bondprices and a fall in the U.S. dollar against the yen.4 Indeed, the behavior of financial and commodity market prices following the release ofthe trade balance report raises a number of questions about both theinfluence of trading catalysts and commonly perceived economicrelationships held by many market participants.
83.00
4/14/87date.open 73.72date.high 75.31date.low 73.16date.close 74.41
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84.00
79.0078.0077.0076.0075.0074.0073.0072.0071.00
4/14/87Merchandise TradeBalance Report
70.0069.0068.003/2/87
4/2/87
5/2/87
Treasury bond market reaction to the February 1987 Merchandise Trade Balance Report on April 14, 1987. Daily trading range of 30 year Treasury bond pricesfrom March 1, 1987 to May 31, 1987.
FIGURE 7.1
The trade deficit sparks a bond market rout.
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Market reactions can be inconsistent across markets. Forinstance, if the trade deficit report was the proximate cause of the risein gold spot and futures prices, why did gold futures prices closesharply higher rather than follow the roller-coaster behavior of bondprices? Why did the rally in the price of gold initially adversely affectbond prices but not later? Put differently, if gold is a good barometerof inflation fears, why didn’t Treasury bonds end the day substantiallylower?News is contained in the forecast error or the difference betweenactual and consensus expectations. The consensus forecast is not whateconomists predict but is the forecast that is in the market—that is,the consensus forecast is what most traders and other market participants think. Consensus expectations need not remain constant overtime. Indeed, the consensus forecast for the February 1987 trade balance probably increased on Monday, April 13 as the bond marketreacted to the rumor of a larger-than-expected trade deficit. Yet, theinitial bond market reaction to the trade deficit report news on Tuesday, April 14 was as if the market had not reacted to a higher-thanexpected number the previous day. Moreover, the effect did not lastbecause the long bond closed only modestly lower for the day. Wasthe initial reaction wrong? If so, why was the initial reaction sowrong? After all, the magnitude of the apparent correction was seventimes the size of the change in the closing price of the Treasury longbond. If it wasn’t a correction, what caused the 1 3/4 point rally inTreasury bond prices from the low of the day to the closing price?The article does not indicate that other news impacted the bond market later in the trading day.Stock prices also fell on April 13 with much of the decline occurring in the last hour of trading and directly attributable to rumors ofthe larger-than-expected trade deficit.5 Spot gold increased $4.25 pertroy ounce on Monday with the rumor of a higher trade deficit.Adding to the concerns of traders was the imposition of a new policy
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of reporting merchandise trade balance data revisions by the Department of Commerce.Taken alone, the immediate reactions of individual markets tonews of a larger-than-expected trade deficit seem plausible and consistent with conventional wisdom about perceived economic relationships. Taken together or viewed over even a marginally longer periodof time, both the initial reactions and the duration of the reactions invarious markets are more puzzling. For instance, if one argues that allof the relevant bond market reaction occurred on Monday after therumor circulated about the larger-than-expected size of the tradedeficit, why was the increase in the price of gold on Tuesday after thetrade balance report announcement three times what it was on Monday? Was there another factor that impacted just the gold market? Ifso, what was it?
The Trade Deficit Sparks a BondMarket RallyAt 8:30 A.M. on Friday, August 29, 1986, the Department of Commerce released the merchandise trade balance report for July 1986.The department reported a record merchandise trade deficit of$18.02 billion for July 1986, a number that would have been evenhigher were it not for $930 million of gold mined outside the U.S. butre-exported to Japan for minting commemorative coins.6 In addition,the merchandise trade balance for June 1986 was revised down from$14.17 billion to $13.25 billion. At the time, the bond market wasarguably in a bullish phase. Once again, the market’s response to thereport was swift and the focus was on the preliminary headline numbers. The dollar fell against its principal counterparts.7 However,unlike the market reaction to the February 1987 merchandise tradereport on April 14, 1987, the prices of U.S. Treasury securities rose
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sharply as depicted in Figure 7.2. Also, unlike the market reaction tothe February 1987 merchandise trade balance report, this time thestock and gold markets were virtually unaffected. The Dow JonesIndustrial Average closed down less than 2 points for the day to1898.34. Spot gold was up $1.25 per troy ounce to $387.75.8 The dollar fell slightly against the yen and Deutsche mark, whereas September 10-year Treasury note futures and 30-year Treasury bond futuresrose about 1 point and over 1/2 point, respectively.9The following excerpt of an article by H.J. Maidenhead that waspublished in The New York Times on August 30 illustrates both theperceived relationship between the trade deficit and interest ratesand likely future Federal Reserve monetary policy actions.Bond investors…aggressively snapped up short- and longterm Treasury debt after the Government reported a recordtrade deficit for July…The deficit for July…also heightenedexpectations of another cut in the discount rate by the Federal Reserve…A soaring trade deficit is a bearish economicindicator.10This was likely the operative trading thesis market participants had inAugust 1986.As with the April 14, 1987 release of the February 1987 merchandise trade balance report, rumors hit the market the day before thatthe trade deficit would be a larger-than-expected $16 billion. A spateof earlier rumors on various economic reports—some of whichproved prescient—lent credence to the rumor (and prompted a laterinvestigation as to whether there was a leak at the Commerce Department).11 The rumor precipitated a rally in Treasury bonds and otherfixed-income securities on Thursday, August 28.12 It also prompted arally in gold with the spot price of gold closing up $5.25 per ounce onThursday.13 Although another report, the Index of Leading EconomicIndicators, was released the same day, contemporary news accountsattributed the price action solely to the trade balance report.
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8/29/86Merchandise Trade Balance Report
80.0079.0078.007/1/86
8/1/86
9/1/86
Treasury bond market reaction to the June 1986 Merchandise Trade Balance Report on August 29,1986. Daily trading range of 30-year Treasury bondprices from July 1, 1986 to September 30, 1986.
FIGURE 7.2
The trade deficit sparks a bond market rally.
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The apparent operative trading thesis for the bond market duringAugust 1986 was that the larger-than-expected trade deficit signaledthe onset of a recession. And recessions are associated with lowerinterest rates, presumably because of a reduction in the demand forcredit holding the supply of credit constant. Therefore, bond pricesrose in reaction to the report.It is interesting to compare the market reactions to the largerthan-expected February 1987 and July 1987 merchandise trade balance reports and the rumors of such that preceded their release. Thedollar fell against its principal counterparts in both cases. Althoughthe price of gold rose in both cases, gold increased more on the rumorthan on the actual report in August 1986, whereas the reverse wastrue in April 1987. Stocks fell in reaction to the release of the February 1987 merchandise trade balance report and to the rumor that preceded it. However, stocks largely ignored the news in the July 1986merchandise trade balance report and the rumor that preceded it.Perhaps the most bizarre reaction to the two reports was in thebond market. As the preceding excerpts make clear, the reaction ofthe bond market to the two reports was 180 degrees different. Bondsrallied to both an actual and rumored larger-than-expected tradedeficit in August 1986, whereas bonds broke in response to an actualand rumored larger-than-expected trade deficit in April 1987. Moreover, the trade deficit report appeared to impact shorter-term securities more during August 1986 than during April 1987. Why thedramatically different bond market reactions to similar trade reportsin the space of less than nine months? Did received economic theorychange during the interim?It would be wrong to focus exclusively on the perceived economicrelationship between changes in the trade deficit and interest rateswithout considering the potential influence of the trade deficit onFederal Reserve monetary policy. An ancillary trading thesis in August1986, at least, was that the Federal Reserve would lower short-terminterest rates. It would do so by reducing the discount rate—the rate
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charged member banks for loans from the Federal Reserve System—in the near future. Put differently, the market reaction to economicannouncements is, in part, a reaction to the presumed future actionsof an important market participant, the Federal Reserve. Anticipatingfuture monetary policy actions by the Federal Reserve or any centralbank is important to traders. Simply put, if the trade balance report isimportant to Federal Reserve monetary policymakers, it is importantto traders.14 That said, it is not clear that this explanation accounts forthe differential reactions of the bond market to similar forecast errorsin the merchandise trade balance report between 1986 and 1987.However, it is clear that perceived economic relationships among market participants can change radically over time.
Scheduled Economic ReportsThere is a decided preference among many market participants tomake trades based on fundamental information and perceived economic information. The large changes in financial and commoditymarket prices and increased volatility that often follow economicreports and announcements seemingly validate fundamentally basedtrading strategies. The periodic release of economic reports offersmarket participants an opportunity to trade off of perceived fundamental economic information. Given that the release of most periodiceconomic reports is scheduled far in advance, traders have the opportunity to assess the outlook, form expectations, compare their expectations with consensus expectations, determine the appropriate sizeof their positions, and time their entry and exit so as to bet largely onthe outcome of the economic report or announcement.At first glance, the market’s rapid reaction to news contained inthe release of economic reports corresponds with what modern financial economic theory would predict15—that is, that new information isquickly impounded into financial market prices in an informationally
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efficient capital market. The academic literature also suggests thatmuch of the volatility in the bond market occurs around economicrelease days and persists for some time after the release.16 Uponcloser inspection, however, anomalies start to appear that questionthe presumption of market efficiency and whether the news in economic reports really represents relevant fundamental economicinformation.As the two opening examples in this chapter demonstrate, themarket’s interpretation of the same forecast errors is not constantover time—that is, the “market’s” interpretation of the implication ofa larger-than-expected forecast error in the merchandise trade balance report changed 180 degrees in the space of less than a year eventhough received economic theory did not change between August1986 and April 1987. Interestingly, the present conventional wisdomabout the impact of a large forecast error on interest rates remainsthe view espoused in 1987.Sometimes, the market appears to overreact to the news contained in economic reports. Other times, markets differ in their interpretation of the news. For instance, gold rose and bonds fell on fearsof higher inflation following the release of the trade balance report.Yet, bonds later rallied while gold remained down even though therewas no apparent news that sparked the rally. Did the February 1987merchandise trade balance report contain significant unanticipatednegative news about future inflation? If so, which market respondedcorrectly to the news contained in the trade balance report—thebond market or the gold market? It would be misleading to leave theimpression that the apparent overreactions of the bond market in theopening examples of this chapter are typical of the market’s reactionto most economic reports.Sometimes, financial markets selectively respond to the news ineconomic reports, seemingly ignoring the news in some cases orresponding opposite to the usual reaction. For instance, as noted earlier, the stock market largely ignored the news in the merchandise
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trade balance report in 1986 but reacted negatively in 1987. Simplyput, the market’s reaction to essentially the same piece of informationmay change over time.Common sense and financial theory alike would suggest that thelarger the forecast error the greater the market’s reaction to any newscontained in economic reports. Yet, this relationship appears to breakdown for large forecast errors, even when the forecast errors areadjusted for differences in dispersion across individual forecasts—Simply stated, large forecast errors are less surprising when there arewide differences in opinion among individuals than when there isnear-unanimity of opinion among market participants. Often, a multiple standard deviation forecast error—which would be consideredextraordinarily unlikely to occur under a normal distribution—doesnot result in an appreciably larger market response than a muchsmaller (and more likely to occur) forecast error. The market’sresponse to a given sized forecast error need not be constant.For example, the magnitude of the impact of a three standarddeviation forecast error on market prices and volatility may differover time. The direction of the impact does not have to differ overtime as it did in the bond market’s reaction to the trade balance reportbetween 1986 and 1987. Rather, the direction of the market’s reactionmay be the same, whereas the magnitude of the market’s reaction differs sharply over time. The difference in the magnitude of the market’s reaction to economic reports underscores the importance ofknowing what the underlying market conditions are.As discussed earlier, financial markets presumably respond to theforecast error in economic reports—that is, the difference betweenthe actual outcome and the consensus forecast. Because economicreports are scheduled, one measure of consensus forecasts is oftenavailable from surveys. Again, the relevant consensus forecast is notwhat economists think but what is in the market—that is, the collective wisdom of market participants. There is also a common presumption that consensus forecasts—however measured—are rational.
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However, that may not be the case because the individual forecastsupon which consensus forecasts are based may not be rational.17Another basic question that arises is which data should the market react to? This seems simple until one understands that most economic reports contain a plethora of data. Notwithstanding the largeamount of data to which the market could react, it appears that themarket reacts largely to the headline number or numbers—for whichconsensus expectations have been formed—even though there maybe other seemingly relevant news in the report. However, even if onefocuses only on the relevant headline numbers in economic reports,the question still arises. What role do revisions to the headline numbers in past economic reports play in impacting market prices? Presumably, fundamentally oriented traders are more interested inaccurate data than less accurate data. Yet, the reverse appears to betrue. Confronted with a choice of reacting to less precise preliminarydata or more precise revised data, participants in financial marketsalmost always opt for reacting to the less precise preliminary data.This highlights another problem that arises with trading off of fundamental information—namely, the undue weight put on preliminarydata. One consequence of this over-emphasis on preliminary data isincreased volatility in financial markets. It also means that traderswho are able to forecast economic variables more accurately (i.e.,closer to the ultimate revised value) may be at a disadvantage totraders who have less accurate forecasting models but produce forecasts closer to the preliminary values of the economic variable inquestion.Not all macroeconomic reports are created equal. Certain economic reports such as the Employment Report and the ProducersPrice Index Report exert more influence on changes in market pricesand volatility than other reports do. Interestingly, what market participants consider the most important economic reports changes overtime. For instance, during the late 1970s and early 1980s, the weeklymoney supply report was considered the dominant report for bond
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market participants. Its significance increased after the FederalReserve switched to targeting monetary aggregates on Saturday,October 6, 1979. The capability of this report to roil fixed-incomemarkets was substantial. Consider, for instance, the reaction of theTreasury bond market to the release of the money supply report bythe Federal Reserve on Friday, April 10, 1981. The bond market’sreaction to the news is captured in this excerpt from an April 13, 1981article in The Wall Street Journal.The money supply news sent the bond markets into a tailspinlate Friday. Prices of some long-term debt securities plungedmore than two points or $20 for each $1000 face amount.Short-term interest rates jumped as much as 3/4 percentagepoint. On the long-term front the Treasury’s closely followed12 3/4 pc bonds due 2010 tumbled to a record low of 95 7/8.The issue closed down at 95 3/4 down from 97 30/32Thursday.18For a while, the release of the weekly money supply reportexerted a tremendous impact on the prices of fixed income securities.Sometimes, long-term bond prices would move as much as threepoints in reaction to an announcement—a huge move in the bondmarket. Then suddenly, the weekly money supply report lost its capability to impact financial markets. Journalists are not accustomed towriting stories about nonreactions to apparent fundamental economicnews, but sometimes they do.19Weekly money supply reports were once highly important forfinancial market participants. Today, they are virtually ignored. Ifmoney supply reports were once important to bond market participants, why aren’t they still important? If money supply reports arenot important for bond market participants, why were they onceimportant?One potential explanation is that the bond market was simplyreacting to changes in what it believed the Fed was targeting—that is,
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bond market participants were trying to anticipate likely Fed monetary policy actions from the forecast errors of the money supplyreport because the Fed was targeting monetary aggregates. Simplystated, if the Fed targets monetary aggregates, bond market participants should watch monetary aggregates. If the Fed targets something else, bond market participants should watch that. Yet, thisargument fails to persuade for several reasons.First, why should fixed-income market participants use highlyvolatile (and hence likely uninformative) weekly money supply figures to forecast monetary policy actions? Indeed, the Fed consideredchanging the frequency of the money supply reports preciselybecause the volatile nature of the weekly reported data made suchdata a poor indicator of monetary trends.20 Second, why should highlyerratic weekly money supply reports affect long-term bond prices?For long-term bond prices to be affected by the money supply forecast error, the change in the (rate of growth of the) money supplyshould be permanent. Again, are short-term fluctuations in themoney supply really indicative of longer-term trends?21 Third, thereport stopped moving financial markets long before the FederalReserve stopped targeting monetary aggregates with the appointment of Alan Greenspan as Fed chairman on August 11, 1987. Putdifferently, if market participants watch the weekly money supplyreports simply because the Fed pursues a policy of targeting monetary aggregates, market participants should continue to react to thereport as long as the Fed continues to target monetary aggregates.
What Is Fundamental EconomicInformation?Two questions naturally arise. First, do economic reports containrelevant fundamental economic information of use to traders? Second, does the market process this information correctly and quickly?
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But an even more basic question must be answered first—namely,what is fundamental economic information?At first glance, such a simple question seems irrelevant—everyone knows what fundamental economic information is. Uponfurther reflection, it is apparent that fundamental economic information is theory dependent—that is, it depends on what financial or economic theory suggests should be the relationship. Do traders andother market participants get these relationships right? Do theyunderstand the nuances of economic theories? Widely believed economic relationships by market participants may be at variance withreceived economic theory. And, there are often competing explanations or theories of economic relationships. Moreover, the explanatory power of many received economic theories may be limited.22Consider, for example, the relationship between an unexpectedchange in the rate of growth of the money supply and changes ininterest rates.1. Is there an impact?2. If so, does it cause interest rates to increase or decrease?3. Does the immediate impact differ from the longer-termimpact?234. Is the impact on the real rate or on inflation expectations?5. What is the mechanism of transmission?6. How long does it last?What does economic theory suggest is the relationship? Theanswer depends on which theory one considers correct. Differenteconomic theories posit different relationships. Unfortunately, thereare a number of macroeconomic and monetary theories to chooseamong. Restricting the set of potential choices to those espoused byeconomists who have won the Nobel Prize in economics gives thefollowing answers.24
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1. Professor Paul Samuelson, a Neo-Keynesian economist whowas awarded the Nobel Prize in 1970, would likely argue thatan unexpected increase in the rate of growth of the money supply would cause the interest rate to fall initially as the supply ofcredit increased in the banking system.2. Professor Milton Friedman, a monetarist who was awardedthe Nobel Prize in 1976 and believes that individuals formexpectations adaptively, would likely argue that the initialdecline in interest rates following an unexpected increase inthe rate of growth of the money supply would be followed byrising interest rates as individuals slowly became aware of theincreased money supply and formed expectations of higherfuture inflation.3. Professor Robert Lucas, another monetarist who was awardedthe Nobel Prize in 1995 and believes individuals form expectations rationally, would likely argue that the initial effect of anunexpected increase in the rate of growth of the money supplyon interest rates is a rise in interest rates.The preceding economic theories have radically different viewsabout the impact of an unexpected increase in the rate of growth ofthe money supply on interest rates. Which theory, if any, is correct?Do most market participants understand the differences among thesetheories? Most likely, they do not. The point is that economic relationships are theory dependent and different economic theories offercompeting views of economic relationships. To complicate matterseven more, other economic theories exist. The preceding three interpretations of the impact of an unexpected change in the money supply are from those economists who believe that the central bankcontrols the money supply.25Market participants sometimes misunderstand the relevant economic variable in economic theories. For instance, market participants commonly confuse changes in relative prices (the price of one
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commodity increases relative to another one) with changes in absolute prices (all commodity prices change). Thus, an increase in theprice of oil or an increase in grain prices is said to be inflationarywhen it may simply represent a change in relative prices. Similarly,changes in the level, or stock, of an economic variable like the moneysupply are confused with changes in the flow, or rate of growth, of theeconomic variable. To the extent that changes in the money supplymatter, it is the change in the rate of growth of money that matters.This makes the former attention devoted by market participants tothe weekly money supply announcements puzzling. Even more puzzling was the substantial response of longer maturity bonds to theseperiodic announcements, because it implied that market participantsassumed the unexpected component of the change in the money supply was permanent.Market participants sometimes perceive economic relationshipsthat may not be there. An example in this regard is the commonlyexpressed concern about the relationship between budget deficitsand interest rates. Although concern over the potential of large Federal budget deficits on interest rates was at one point shared by allthree major candidates in the 1992 U.S. presidential election—and iswidely shared by many market participants—there is little evidenceto support this notion in the academic literature.A lot of widely believed relationships are what economists wouldcall partial equilibrium relationships—that is, relationships that explainonly a part of the effects associated with a price change. To considerbut one example, it is widely believed that currency devaluation—forexample, in the dollar—improves the trade balance by making foreigncurrency denominated imports more expensive to U.S. consumers andU.S. dollar-denominated exports less expensive to foreigners. Theessential flaw in this argument is that it assumes that prices are setlocally rather than globally. For instance, suppose the exchange ratebetween the euro and the dollar is one to one—that is, $1 sells for €1.Suppose further that gold sells for $400 per troy ounce and €400 in
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eurozone countries before a sudden 50% devaluation of the U.S. dollaragainst the euro, so €1 will buy $2. Conventional wisdom would suggest that the U.S. would suddenly export more goods (including gold)because eurozone residents could buy them more cheaply in theStates. In the first instant after devaluation, a U.S. gold mining firmfaces the choice between selling gold for $400 in the States or theequivalent of $800