ate a price move opposite to the sentiment bias as traders move to cover losing positions.There is a time dimension to sentiment bias as well—that is, sentiment bias may vary across the short-term, medium-term, and longterm. For instance, a trader could have a negative outlook on thestock market for the medium- or long-term but be bullish about itsprospects for the short-term. The same is true for the market overall.These differences are important to understand as they impact howlong a trade is held and may also impact the position size a traderputs on.Market conditions and sentiment bias may interact with anddepend on each other. It is easy to imagine various market conditionscombined with various sentiment biases. Numerous combinations arepossible.8 In a sense, market conditions and sentiment bias are analogous to the amount of dead trees and other easily combustible material on a forest floor. Other things equal, the greater the amount ofeasily combustible material on a forest floor the greater the danger ofa forest fire from a lightning strike and the worse the fire is likely tobe. Similarly, gauging market conditions and sentiment bias is important in evaluating the potential power and duration of a trading catalyst on prices should a trading catalyst spark a move in prices.
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Perceived market conditions also influence trading decisions inaccordance with how one expects the market to behave. For example,there is a widespread belief that growing economies are characterizedby rising interest rates. The reasoning is simply that there is a greaterdemand for credit when the economy is expanding. This means thatinterest rates should rise, holding the supply of credit constant. During the summer of 2004, many traders expected long-term interestrates to rise with the growing economy and long rates to rise morethan short rates, causing the yield curve to steepen. Put differently,perceived market conditions were the essential premise behind thistrade. In this instance, the trade did not work out and one investmentbank reportedly lost several hundred million dollars on the trade.It is important to recognize that traders are often looking for askewed distribution when others see a symmetric distribution. Wheneveryone is on one side of the market (figuratively speaking), the onesided trade can easily reverse. Simply stated, traders are searching fortrades with outsized rewards with little or moderate risk. It might beargued that skewed distributions are more likely to exist when marketparticipants share common beliefs and market expectations—that is,when there is substantial sentiment bias. Skewed distributions neednot be inherently more common under one set of market conditionsthan another. However, as shown in Chapter 6, “Market Interventions,” skewed distributions may be more likely at turning points.Not only do market conditions and sentiment influence the magnitude and duration of the market’s response to a trading catalyst, butmarket conditions and sentiment influence the breadth of the pricemove. This may cause a catalyst that might otherwise affect a singlecommodity or security to affect the overall market. Market conditionsand sentiment may also influence the direction prices move in reaction to a trading catalyst as well as how long a trading catalyst impactsmarket prices. In some cases, market conditions and sentiment maycause a potential trading catalyst to be ignored. In other cases, withdifferent market conditions and sentiment levels, the same tradingcatalyst may exert a powerful impact on market prices.
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Consider the Treasury announcement to discontinue issuance of30-year Treasury bonds discussed previously. As noted in Footnote 2,The Wall Street Journal article on the announcement reports: “manyWall Street traders were betting the price of the security would dropnot rise. Some had sold 30-year bonds short, borrowing and sellingthem.” This illustrates the prevailing bearish sentiment among manymarket participants that there would be increased supply of thebonds as the government financed “new spending programs resultingfrom the Sept. 11 terrorist attacks.” It also illustrates a common trading position that many market participants had on at the time. Thefact that many, presumably key, market participants were short bondsmeant that any catalyst that prompted a rise in Treasury bond pricescould trigger a short covering rally as traders with short positionsmoved to limit their losses. This, in turn, would exacerbate the market’s reaction to the news.9 This illustrates how market conditions andsentiment bias can exacerbate a price move.Although the general tone of the market may be easy to assess,the degree of market sentiment bias is more difficult to measure.Some market observers use price action as a proxy for market sentiment. This can be misleading because some of the largest jumps inprices may occur when the overall market is bearish and some of thelargest declines in prices may occur when overall sentiment in themarket is preponderantly bullish. An example of the latter would bethe stock market crash of 1929.Reverses can occur suddenly as well. For instance, recall theexcerpt from the January 11, 2005 issue of The Wall Street Journalthat was discussed in Chapter 1, “Introduction,” and reported a bullish short-term market bias for energy.10 At one point, crude oilfutures were up almost $2 per barrel, setting a multi-week high. Yet,crude oil prices fell to close $.10 below the level of the previous day.Simply stated, a significant price break occurred quickly in amarket with a bullish short-term outlook.
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It might be argued that knowledge of market conditions and sentiment bias is more important in assessing the impact of news than onscheduled economic reports and other similar announcements. In thelatter case, information on consensus expectations may be available;whereas in the former case, it most often is not. Earnings announcements are another example of potential trading catalysts whose timing is often scheduled. As was stated earlier, scheduled tradingcatalysts allow for more precise estimates of consensus expectations.However, sometimes even a slight disappointment in earnings canlead to sharp declines in a stock’s price. Consider, for example, eBay’sannouncement of 2004 fourth-quarter earnings as reported in theJanuary 20, 2005 issue of the Financial Times.eBay failed to live up to Wall Street expectations when itannounced fourth quarter earnings yesterday, prompting asharp reversal in its stock price in after-market trade…Investors…wipe[d] more than 11 per cent from the stockprice.eBay’s latest earnings per share, at 33 cents, slipped a centbelow expectations…After a stock price rally that has seenthe shares soar by more than 300 per cent over the past twoyears, the mild shortfall brought a sharp reaction frominvestors. Shares were down $11.96 in after-hours trading at$91.09…11The preceding example is interesting for several reasons. First, itdemonstrates how even a small forecast error can have a dramaticeffect on market prices. The one-cent miss in fourth-quarter earningsaccounted for about 3% of earnings, but the stock price fell threetimes that amount. This example also illustrates the importance of themarket environment on the behavior of prices. Notice how the articlenotes how the past sharp 300% increase in the stock price made themarket for the stock vulnerable to a larger decline in the stock’s price.This gives a better sense of the interrelationships between marketconditions and sentiment bias.
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TRADING CATALYSTS
The level of risk aversion impacts financial and commodity market prices by affecting the risk premium that market participantsdemand. A sudden increase in risk aversion can cause a sharp drop infinancial market prices.A fundamental belief of most traders is that market conditionsrecur with some frequency. And because they recur, traders may lookat how the market responded to a given trading catalyst in the pastunder similar market conditions and sentiment bias to gauge how market prices are likely to respond this time. Another way to look at this isthat the response of market prices is conditional upon market conditions and sentiment (or as economists might say, the state of the world).Thus, traders speculating at the end or the sudden beginning of a warmight look at the reaction of financial markets the last time war beganor ended. The same is true of traders trying to anticipate the impact ofthe first in an anticipated series of Federal Reserve interest rate cuts orhikes. As noted in Chapter 1, this is called event time.When there are multiple occurrences of similar events undersimilar market conditions, the question naturally arises as to howmuch weight should be attached to past events. One approach is totake advantage of the larger sample size and use an average of pastmarket reactions to get a measure of the market’s likely reaction.Another approach is to attach greater weight to the more recentevents. The latter approach is probably more commonly employed bytraders. There is also some theoretical justification for it. Again, asnoted in Chapter 1, the French economist and 1988 Nobel Laureatein Economics, Maurice Allais, posited a rate of forgetfulness in whichthe weight attached to past observations declines as time passes.12
Treasury Announcement of PotentialResumption of 30-Year Bond IssuanceThe Treasury’s decision to discontinue issuance of 30-year bonds inOctober 2001 is made more interesting by the announcement on
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Wednesday, May 4, 2005 that the U.S. Treasury was consideringwhether to resume issuance of 30-year bonds. The announcementwas made at about 9:00 A.M. by Assistant Treasurer TimothyBitsberger. He noted that a final decision on whether the Treasurywould resume issuance of 30-year bonds would be made in August2005. Not surprisingly, the announcement sparked a sharp sell-off in30-year Treasury bonds. The excitement of the day’s market actionwas captured in the following story that was reported onBloomberg.com on May 4, 2005.The 30-year U.S. Treasury bond had its biggest drop inalmost two months after the government said it may resumesales…The 5 3/8 percent bond due in February 2031 fell asmuch as 8.5 points, or $85 per $1,000 face amount, in theminutes after the announcement as investors suddenlybecame concerned about more supply.The bond pared some of its losses in afternoon trading, andwas down about 1 3/4 to 111 25/32 at 5:05 P.M. in NewYork…The yield rose 11 basis points,…to 4.59 percent…Theyield reached 5.02 percent as its price tumbled to 105 soonafter the 9 A.M. announcement. The plunge was the biggestfluctuation of any government debt security today.13The behavior of Treasury bond prices in reaction to theannouncement is both instructive and puzzling. One would expect asharp sell-off in Treasury bond prices given the huge rally that followed the announcement 3 1/2 years earlier that Treasury bondissuance would be discontinued. Indeed, bond prices dropped a massive 8.5 points initially. This decline in Treasury bond prices wasalmost the same size (in absolute value terms) as the combined twoday nine-point rise in Treasury bond prices on October 31 andNovember 1, 2001. The initial drop in bond market prices might beattributable to the fact that many traders remembered what happened 3 1/2 years earlier when 30-year Treasury bonds were discontinued and expected the reverse to happen when the announcementwas made that issuance might be resumed. Rather than happening
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TRADING CATALYSTS
over two days, the effect was telescoped to an immediate sharpdecline. This is an example of event time. Traders look to what happened when 30-year Treasury bonds were discontinued in order toanticipate what will happen when issuance is likely resumed. Thewide trading range in Treasury bond prices is depicted in Figure 2.3.After the initial sharp decline following the announcement, Treasury bond prices rose enough to recover most of the early losses. Theexcerpt notes that Treasury bond prices closed down 1.75 points toclose at 111. This behavior is more puzzling. The question naturallyarises as to why the market’s response to the Treasury announcementwas so short-lived relative to what happened on October 31, 2001 andNovember 1, 2001. Once again, part of the difference may lie in market conditions and sentiment bias.The dearth of liquidity that accompanied the massive pricedecline made transactions difficult and made it easier for bids to pushprices up. Unlike the situation in 2001 where many market participants were short the long bond, there may have been a lack oftrading positions that would reinforce the price decline like the shortcovering trades in 2001 reinforced the price rise. To be sure, priceswere at their lowest for only a relatively short time period.It should also be noted that unlike the October 31, 2001announcement discontinuing further issuance of 30-year Treasurybonds, the May 4, 2005 announcement was qualified. Indeed, Assistant Treasury Secretary Bitsberger indicated that a final decision onwhether 30-year Treasury bond issuance would resume would bemade in August 2005, opening up the possibility that long bondissuance would not be resumed. The belated realization that there-issuance was conditional rather than unconditional could havemitigated the reason for a sharp price decline.
119.005/4/2005Treasury announcement
118.00117.00116.00115.00114.00113.00112.00111.00
5/4/2005date.open 112.9375date.high 113.7500date.low 109.0938date.close 111.8375
110.00109.00108.00
CHAPTER 2 • MARKET CONDITIONS AND SENTIMENT
120.00
107.00106.002/1/05
3/1/05
4/1/05
5/1/05
6/1/05
7/1/05
Reaction of the 30-year U.S. Treasury bond to the May 4, 2005 Treasury announcement. Daily trading range of the cash market 30-year Treasury bond fromFebruary 1, 2005 to July 31, 2005.
The Treasury reconsiders issuance of the long bond.
49
FIGURE 2.3
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TRADING CATALYSTS
As was the case for the October 31, 2001 announcement, CBOTTreasury bond futures contracts moved less than the cash marketTreasury bond. The behavior of Treasury bond futures prices aroundthe announcement day is depicted in Figure 2.4. June 2005 Treasurybond futures contracts opened at 115 5/32 at 8:20 A.M. Eastern timeand stood at 115 1/32 at 9:00 A.M. a few moments before theannouncement. At 9:00:21 the price of the June T-bond futurescontract fell suddenly by 6/32. Prices fell another 6/32 and stood at114 21/32 at 9:00:33, and a fast market was designated. By 9:01:01 thecontract was trading at114 11/32. The contract traded 4/32 lower at9:01:57. Thirty seconds later, the contract was trading 5/32 higher at114 12/32. Another 30 seconds later, the contract was trading at 11414/32. At 9:09:00 the contract traded at 114 6/32 and the fast marketdesignation was lifted. The market started to break again a few minutes later and stood at 113 18/32 when it was designated a fast marketfor a second time at 9:20:39. The fast market designation was liftedless than 10 minutes later when the contract traded at 113 27/32. Themarket bounced around but generally rose throughout the day andstood at 114 22/32 at 14:59:57.Clearly, the announcement served as a trading catalyst for theTreasury bond futures market. Equally clearly, the price action in theTreasury bond futures market paled in comparison with the priceaction in the cash market. The price action in Treasury bond futureswas relatively short-lived. One interesting characteristic of the Treasury bond futures trading was that there were two periods of intensetrading and price choppiness sufficient to warrant a fast market designation.14 A trader who shorted the Treasury bond futures market andcovered his position at 3:00 P.M. would have made 11 ticks at most, or$343.75 per contract.
119.00118.00117.00116.00115.00114.00113.00112.005/4/2005date.open 115.1563date.high 115.1875date.low 113.4688date.close 114.6563
5/4/2005Treasury announcement
111.00110.00
CHAPTER 2 • MARKET CONDITIONS AND SENTIMENT
120.00
109.00108.002/1/05
3/1/05
4/1/05
5/1/05
6/1/05
7/1/05
Reaction of CBOT Treasury bond futures prices to the May 4, 2005 Treasury announcement that it was reconsidering issuance of the long bond. Daily tradingrange of first month CBOT Treasury bond futures prices from February 1, 2005 to July 31, 2005.
FIGURE 2.4
Treasury bond futures prices react.51
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Both the initial reaction to the announcement and the duration ofthe impact that this trading catalyst exerted on market prices areinteresting. Clearly, there was an immediate negative reaction to theannouncement. Equally clearly, the reaction took some time beforethe full impact was felt. The first large downward drop in pricesoccurred at 9:00:24 when Treasury bond prices fell almost one quarter of a point instantly. The next jump occurred a moment later whenprices fell another 5/32.The price action in the cash Treasury bond market is instructive.Prices fell in the cash bond market as they had in the Treasury bondfutures market. It appears that the price action in the Treasury bondfutures market led that of the corresponding cash market by a fewseconds. The first price break occurred at 9:00:24 when cash bondsfell by approximately 6/32 to 112 53/64. Prices held there for a fewseconds before falling to 112.217 at 9:00:30. The price decline continued. The price moves accelerated less than a minute later and stoodat 111.132 at 9:01:21. Three seconds later, prices suddenly fell almostthree points to 108.276. Another three seconds later at 9:01:27, pricesof Treasury bonds collapsed seven whole points and stood at 101.226.This situation lasted for almost three seconds before rising threepoints to 104.202. Prices quickly recovered.It should be pointed out that the bid offer spread widened dramatically during the short period of time that cash market bondprices were collapsing. At one point, the bid offer spread stood atmore than 4 points, or 256/64, in a market where the bid offer spreadis often just 1/32 or a plus (i.e. 1/64). This is an absolutely enormousbid offer spread. In sharp contrast, the implicit bid offer spread inTreasury bond futures prices remained relatively tight throughout theimmediate post-announcement period.In addition to impacting outright trades, the Treasury’s announcement had implications for yield curve trades. Specifically, the
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Treasury’s announcement raised concerns about potential changes inthe shape of the yield curve. The prospect of additional supply at thelong end was interpreted as implying a steepening yield curve. Thisencouraged many market participants to put on steepening trades (i.e.,short long-maturity Treasury bonds and long shorter-maturity Treasury notes) in the belief that long-maturity bond prices will fall relativeto shorter maturity notes and bonds. Indeed, the May 5, 2005 Financial Times reported that “the yield curve steepened sharply [after theTreasury announcement], with the gap between 10 and 30 year yieldswidening to 40 basis points on Tuesday.”15 This is a huge one-daymove in a yield curve spread trade.It should be noted that despite the substantial impact that bothannouncements exerted on Treasury bond prices, other financial markets were largely unaffected by the price action in the Treasury bondmarket. There were no spillover effects from the two Treasuryannouncements on equity prices. There was some impact on otherfixed-income securities. In particular, the on-the-run (i.e., mostrecently issued and usually most actively traded) 10-year Treasurynote fell about half a point soon after the news broke. However, unlikethe long bond, the reaction in the 10-year Treasury note was shortlived in that prices soon stabilized at the new, somewhat lower level.It is interesting to speculate how the Treasury bond market wouldhave reacted under different market conditions and sentiment bias.What if the announcement to potentially resume issuance had beenmade in the early summer of 2004 during a period when there was awidespread belief that a strengthening U.S. economy would lead tosignificantly higher long-term interest rates? How would a sentimentbias toward rising long rates have affected the observed reaction?Conversely, what impact would the announcement that the Treasurywas going to discontinue issuance of 30-year bonds have had if it hadbeen made in a bullish bond market environment?
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Trading LessonsA trader’s thesis as to how financial and commodity markets shouldrespond to a given trading catalyst depends, among other things, onthe market conditions and sentiment bias that prevail at that momentin time. However, there are a large number of potentially significantmarket conditions at any moment in time. For instance, the Fed maybe pursuing an expansionary monetary policy during an economicrecession, a presidential election year, and a period of dollar weakness. In such an environment, the trader has to decide which marketconditions matter and which ones do not. Defining market conditionsbroadly facilitates comparing the present situation with similar situations in the past to guide trading decisions. Even broadly definedmarket conditions may result in only a few observations, making itdifficult to infer the future from what happened in a similar event inthe past.One question that occurs is the weight to attach to various marketconditions at any point in time. Suppose that the Federal Reserve iscontinuing to pursue an expansionary monetary policy during an economic expansion as it did during part of the 1990s. Several questionsnaturally arise. Should one give more weight to the fact that the Federal Reserve is pursuing an expansionary monetary policy or to theeconomic expansion? Are the weights attached to various market conditions constant or do they change over time? What would prompt atrader to change the assigned weights?Market conditions and sentiment bias may explain why there issometimes a strong market reaction to a catalyst even though thenews is not a surprise. Consider the following example from the February 4, 2005 issue of the Financial Times.The US dollar spiked higher yesterday, although quite why itdid so was less clear. Most analysts and traders cited theimproving yield differential of US assets, with the EuropeanCentral Bank [ECB] yesterday holding its key repo rate at
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2 per cent just a day after the Federal Reserve sanctioned a25 basis point rise to 2.5 per cent.Yet no one should have been unduly surprised by these developments, or indeed the simultaneous clues as to the futuredirection of monetary policy.The Federal Open Market Committee’s universally expectedincrease was accompanied by a near-identical statement…proffered after December’s meeting.Likewise, the 20th straight month of inaction from the ECBcame as no surprise…With such sentiment to the fore, theUS dollar rose 0.6 per cent to $1.2956 to the euro…0.9 percent to $104.64 against the yen and 0.3 per cent to $1.8794against sterling.16Although a strong reaction could occur for a zero forecast error ifthere is substantial dispersion in forecasts, there is no evidence that isthe case here. Rather, the reason for the sharp response to an expectedevent most likely lies with market conditions and sentiment bias.Part of the reason for focusing on market conditions is to anticipate how other market participants are likely to react to a given trading catalyst. The use of event time can cause traders to react earlierthan they otherwise would as they try to avoid missing the trade—thatis, a market reaction that took some time to complete might be telescoped into a much shorter time period as traders attempt to avoidmissing the trade. This happened in the market’s reaction to the Treasury’s announcement that it was considering issuing 30-year Treasurybonds again.It is possible to imagine trading catalysts that affect volume without affecting the direction of price changes or trading catalysts thataffect volatility without affecting the direction of prices. For example,the prospective imposition of a transactions tax can cause market participants to advance their trading before the tax increase becomeseffective. Likewise, the prospective reduction of a tax can cause volume to decrease before the tax cut becomes effective. The same is
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true for the elimination of fixed commissions. The “Big Bang”resulted in a sharp increase in trading volume on October 26, 1986when fixed stock brokerage commissions were abolished in GreatBritain. Similarly, the flawed U.S. presidential election of 2000resulted in an increase in market uncertainty without arguably a corresponding impact on market prices. However, most of the time,trading catalysts that impact volume or volatility will also impact thedirection of market prices.Liquidity affects the sensitivity of market prices to various catalysts as well. Traders usually prefer to trade in liquid markets. As aresult, sometimes the most liquid markets are where traders placetheir bets even though a trading catalyst may have a more pronounced impact on less liquid markets. Information tends to bereflected in more liquid markets first. Similarly, trading depth—thevolume that one can transact without impacting a security’s price—differs across markets. Other things equal, the deeper the market, theless impact that a trading catalyst may have on the price of a security.Market conditions and sentiment bias affect the power, duration,and breadth of a trading catalyst’s impact on prices and may partiallyexplain the inconsistent market reactions to seemingly similar tradingcatalysts over time. Other things equal, a given trading catalyst in atranquil or quiescent period is less likely to impact market prices asmuch than one in a turbulent period. Sometimes, a trading catalystcan trigger both a price move and cause a shift from a tranquil marketenvironment to a turbulent market environment such as the Iraqiinvasion of Kuwait in the summer of 1990 did to financial markets.Anything that shakes the confidence of market participants increasesthe risk premium traders and investors discount future cash flowswith. Changes in the risk premium also exert a powerful influence onmarket prices.
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ReferencesAllais, Maurice. “Forgetfulness and Interest.” Journal of Money,Credit and Banking. Vol. 4, Issue 1, February 1972, pp. 40-73.Bahree, Bhusan, and Chip Cummins. “Energy-Price VolatilityReturns Due to Output Outages, Weather.” The Wall Street Journal,January 11, 2005, p. C5.Balls, Andrew, Richard Beales, Joanna Chung, Jeremy Grant, andGillian Tett. “US Treasury Might Reissue 30-Year Bonds.” FinancialTimes, May 5, 2005, p. 23.Bloomberg News (http://www.bloomberg.com), May 4, 2005.Financial Times, May 5, 2005.Johnson, Steve. “Greenback Makes Strong Gains.” Financial Times,February 4, 2005, p. 26.Keynes, John Maynard. The General Theory of Employment, Interestand Money. New York: Harcourt, Brace and World, 1935.Securities and Exchange Commission. “SEC Brings EnforcementActions Against Three Individuals, Goldman Sachs, and Massachusetts Financial Services Company Related to Trading Based on NonPublic Information About the Treasury’s Decision to Cease Issuanceof the 30-Year Bond.” (http://www.sec.gov/news/press/2003-107.htm), September 4, 2003.Securities and Exchange Commission. “Speech by SEC Staff:Remarks to Announce the Filing of Actions Related to Trading Basedon Non-Public Information About the Treasury’s Decision to CeaseIssuance of the 30-Year Bond.” (http://www.sec.gov/news/speech/spch090403smc.htm), September 4, 2003.Securities and Exchange Commission. “Former Goldman EconomistYoungdahl Agrees to Fraud Injunction and $240,000 Penalty in SECTreasury Bond Insider Trading Case.” (http://www.sec.gov/news/press/2003-155.htm), November 12, 2003.
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Sun Tzu. The Art of War.Waters, Richard. “eBay Shares Fall by 11% as Earnings Falter.”Financial Times, January 20, 2005, p. 1.Zuckerman, Gregory, and Michael Schroeder. “Goodbye to the30-Year Treasury—U.S. Decides to End Its Sale; ‘10 Year’ Reigns.”The Wall Street Journal, November 1, 2001, p. C1.
Endnotes1
Sun Tzu, The Art of War.
2
Gregory Zuckerman and Michael Schroeder. “Goodbye to the 30-Year TreasuryBond—U.S. Decides to End Its Sale; ‘10 Year’ Reigns.” The Wall Street Journal,November 1, 2001. The article notes that: “…The sharp jump for the 30-yearbond came as many Wall Street traders were betting the price of the securitywould drop not rise. Some had sold 30-year bonds short, borrowing and sellingthem, hoping to buy them back at a lower price.”
3
Specifically, the contract allows delivery of noncallable Treasury bonds withmaturities equal or greater than 15 years to maturity or callable Treasury bondsthat aren’t callable for at least