(€400) in the eurozone. Would U.S. gold miningfirms really sell gold for half of what it would fetch in Europe? No.What would happen to the dollar price of gold? The dollar price of goldwould simply double. The point is that rather than stimulating exportsand economic output, a devaluation of the dollar against the euro stimulates higher dollar prices on tradable goods. Again, from a tradingperspective, it is not important whether other market participants getthe theory right but how their actions would likely affect prices.
Noise and InformationThere is a presumption that the large price moves that often followthe release of key economic reports is evidence that financial marketsmust be reacting to the arrival of new fundamental economic information. Furthermore, the rapid reaction of financial markets is oftentaken as evidence of market efficiency. However, markets need notbe efficient, and the news in economic reports need not representrelevant fundamental information for financial market participants.If financial and commodity markets are not reacting to the arrivalof new fundamental economic information when economic reportsare released, what are they reacting to? Although financial marketsreact to news, news need not contain relevant fundamental economicinformation. It may also contain noise—nonfundamental informationthat impacts market prices. The late Fisher Black, co-developer ofthe Black-Scholes option pricing model, argued that noise trading is anecessary condition for active, liquid financial markets and that noisetraders create the mispricings that value investors exploit.
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The quintessential example of noise is the addition of a new stockin an index like the S&P’s 500 stock index.26 The price of the stockthat is added to the index typically rises after the announcement asindex funds and other portfolio managers rush to include the stock(or increase its weight) in their portfolios. Yet, fundamentally, nothinghas changed about the underlying company. It still has the sameexpected future cash flows. Absent a reduction in the discount rate,the price of the stock should remain unchanged following its inclusion in the portfolio. Another result of noise trading is that it causesexcessive volatility in financial market prices in the short-run.It is possible that much of the puzzling behavior in the precedingexamples of the market’s reaction to economic reports might beexplained by noise. Simply stated, much apparent macroeconomicnews is noise rather than fundamental information.
Trade Selection and Trade HorizonAt any point in time, traders face a myriad of choices as to where toplace their trades and how large to make their bets. Simply stated,some markets may not be as sensitive to the news contained in aneconomic report as other markets. For those traders with a view onthe likely forecast error and market reaction, the size of the tradingposition should vary directly with their confidence in their forecasts.For instance, at 8:30 A.M. on Friday, September 5, 2003, theDepartment of Labor released the Employment Report for August2003. The attention of traders and other market participants was initially focused on two headline numbers: the unemployment rate andthe change in nonfarm payrolls, a measure of new jobs created duringthe month. Attention focused on the Employment Report because ofthe widespread belief among many market participants that thestrength of the economy (as reflected in the employment situation)and interest rates are inversely related and that the Employment
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Report may be a harbinger of Federal Reserve monetary policyactions. Some market participants squared or hedged trading positions going into the employment report; others took out new oradjusted existing positions in advance of the report’s release. Fixedincome traders were especially interested in the report but the reportinfluenced the currency, equity, and commodity markets as well.The Department of Labor reported that the unemployment ratein August 2003 fell to 6.1% and the number of new jobs created during August (i.e., nonfarm payrolls) fell by 93,000. The departmentalso reported that the number of new jobs created in July 2003was revised to down 49,000. The average work week remainedunchanged, whereas average hourly earnings were up 2 cents. Jobswere lost in the manufacturing sector for the 37th consecutive month.The consensus forecasts for the unemployment rate and the changein nonfarm payrolls was 6.2% and +12,000, respectively.27 If the consensus forecasts were the actual forecasts in the market, the forecasterrors were -.1% for the unemployment rate and 105,000 for nonfarm payrolls.The operative trading thesis going into the report was that aweakening economy as evidenced by a higher unemployment rate orfewer jobs created would boost bond prices as people anticipatedreduction in the demand for credit and lower interest rates. In thisinstance, traders are faced with conflicting information—the unemployment rate is down indicating a strengthening economy, whereasthe number of new jobs created is down indicating a weakening economy. Traders must decide how the market will react if there is conflicting information about the state of the economy in the report. Andif so, which data should the trader focus on? At one time, more attention was paid to the unemployment rate; at present, more attention ispaid to the nonfarm payrolls number.As should be readily apparent by now, it is not important tounderstand what economic theory suggests about how the marketshould react to the forecast errors in the Employment Report.
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TRADING CATALYSTS
Rather, it is important to understand how the market, as a whole, islikely to respond to it and which market will be most sensitive to thereport. In addition, the trader who wants to bet primarily on thereport’s outcome must determine when the trade should be put onand taken off.Consider the reaction of the December 2003 10-year Treasurynote futures contract traded on the Chicago Board of Trade. At thetime of the report, the December 2003 T-note futures contract wasthe most actively traded contract month. The futures price was at109-20 at 8:20 A.M. on Friday, September 5, 10 minutes before thereport was released. The market stood at 109-20+ a moment beforethe news came out at 8:30 A.M. By the end of the first minute of trading after the announcement, the market was at 110-08+. The minimum price move, or tick, is 1/64 and has a dollar value of $15.625.Thus, the 40-tick move by 8:31:00 A.M. translates into a $625 profit orloss per futures contract. One minute later, the market stood two tickshigher at 110-09+. Five minutes after the announcement, the markettraded at 110-08+. The market remained around the 110 level foralmost the next half hour and then moved slightly higher. The marketstarted to climb higher around 12:36 P.M. The high of the day (11031+) was reached toward the end of the regular trading session. Themarket closed at 110-30+ or 48.5/32 (97 ticks) above the previousclose of 109-14.A long position in the 10-year Treasury note futures contractentered at Thursday’s closing price of 109-14 and exited at Friday’sclose of 110-30+ would have made $1515.62 per contract, ignoringtransaction costs—that is, $15.625 x 97 or 48.5 x $31.25. This positionwould have entailed the risk of holding the position overnight andlong after the report came out. In contrast, a long position placed atthe opening of pit trading (i.e., at 8:20 A.M.) on Friday at 109.20 andexited after the first two minutes of trading at 110.09+ would havemade $671.87 per contract (i.e., $31.25 x 21.5) and exposed the traderto risk for 12 minutes.
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This ignores transaction costs and assumes that the trader wouldhave entered or exited at the indicated prices. In reality, a traderwould face the prospect of slippage, execution delay, and brokeragecommissions, all of which would reduce the potential profit fromsuch a trading position.The question naturally arises as to whether there were bettertrades in the fixed income or currency markets that might have beenmade. The answer depends on the desired trade horizon—how long atrading position is kept open. Table 7.1 compares the potential trading profits and losses from buying a single futures contract in the2-year Treasury note futures, 10-year Treasury note futures, 30-yearTreasury bond futures contract, EuroFX futures, or Japanese yenfutures contract in advance of the employment report and holding itfor as short as 12 minutes or as long as one day. The 2-year Treasurynote and 30-year Treasury bond futures contracts are traded on theChicago Board of Trade, whereas the EuroFX (i.e., the euro currencyfutures contract) and Japanese yen futures contracts are traded onthe Chicago Mercantile Exchange. The sensitivity of interest ratefutures contracts to changes in interest rates depends upon theimplied duration—a measure of interest rate risk. The 2-year Treasury note futures contract has the smallest duration, whereas the30-year Treasury bond futures contract has the greatest duration. The2-year Treasury note is considered more sensitive to Fed monetarypolicy actions. It trades in quarter points on $200,000 of notionalprincipal.28 The tick value is $15.625.The potential profits from the long 10-year Treasury note futuresposition and 30-year Treasury bond futures position are similar. Notsurprisingly, given its lower sensitivity to changes in interest rates (orimplied duration), the 2-year Treasury note futures contract produced smaller trading profits than either the 10-year Treasury note or30-year Treasury bond futures contracts. A quick examination ofTable 7.1 reveals that the largest profits occurred with trades held foran entire day. Although it worked out in this instance for traders with
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TRADING CATALYSTS
long positions, it is a fundamentally flawed strategy, however, becauseit entails assuming unnecessary risks. It is not clear whether the largeend-of-day price moves can be attributed to the employment report.It is also possible that, the subsequent price changes were due toother news.TABLE 7.1 Market Reaction of Selected Futures Contracts to theAugust 2003 Employment Report on September 5, 20032-YearT-NoteDec. 2003Futures
10-YearT-NoteDec. 2003Futures
30-YearT-BondDec. 2003Futures
EuroSept.2003Futures
YenSept.2003Futures
Thursday Close
106-21
109-14
104-27
109.22
.8569
Friday 8:20
106-22+
109-20
105-04
109.23
.8563
Friday 8:29:59
106-22+
109-20+
105-05
109.23
.8565
Friday 8:31:00
106-26
110-08+
105-21
109.55
.8568
Friday 8:32:00
106-27+
110-09+
105-24
109.70
.8573
Friday 8:35:00
—
110-08+
—
109.80
.8574
Friday Close
107-032
110-30+
106-22
111.03
.8562
Max. PotentialProfit 12-minuteTrade Horizon
$312.50
$671.87
$625
$587.50
$125
Max. Potential$890.62Profit1-Day Trade HorizonClose to Close
$1515.62
$1,843.75
$2,262.50 –$87.50
8:20:00-8:32:00
The 2-year Treasury note futures contract has a notional principal of $200,000, whereas the 10year and 30-year Treasury bond futures contracts have a notional principal of $100,000. TheJapanese yen futures contract has a notional principal of ¥12,500,000 and the EuroFX futurescontract has a notional principal of €125,000. All of the contracts are traded on a quarterly expiration cycle with futures contracts expiring in March, June, September, and December.
The trading lesson is simple. If the bet is on the outcome of aneconomic report, the trade horizon should be relatively short to avoidexposing the trading position to unnecessary risks. Another lessonthat emerges is that the highest trading profit came from holding acurrency futures position rather than an interest rate futures position.
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217
It is not apparent that the differential reaction between the currencyand interest rate futures markets could have been ascertained inadvance. Moreover, an individual who bet on yen futures rather thanthe EuroFX futures would have lost money. Therefore, it is alsoimportant to pick the currency that will react as anticipated. Table 7.1indicates the importance of placing the bet on the right security butalso illustrates the difficulty in doing so.
Trading LessonsThe release of economic reports often acts as a trading catalyst infinancial markets by precipitating substantial changes in marketprices and volatility. Although scheduled economic reports offer market participants a seeming opportunity to trade off of fundamentaleconomic information, the opportunity may be more apparent thanreal. Much of the news in the reports may represent noise rather thanfundamental economic information.Fundamental economic information is theory dependent—thatis, theory determines what fundamental economic information is.Sometimes, economic theory is silent on the impact of forecast errorsfrom economic reports on financial market prices. In other cases, theexistence of plausible competing economic theories means that eventhe direction of the impact of forecast errors from some economicreports may be controversial.Many commonly held beliefs about economic relationships bymarket participants may differ substantially from received economictheory. For instance, market participants often confuse changes inrelative prices (e.g., an increase in the price of oil) with changes inabsolute prices (i.e., inflation). Moreover, consensus beliefs aboutthe meaning of forecast errors from economic reports can changesuddenly. Witness the 180-degree difference in interpretation of alarger-than-expected trade deficit report on bond prices between
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TRADING CATALYSTS
August 1986 and April 1987. In other cases, formerly closely watchedeconomic reports can suddenly lose their capability to move markets—as happened with money supply announcements during the 1980s.Sometimes, forecast errors from an economic report will occasionally act as a trading catalyst that pushes the market in the direction opposite of what was expected. Sometimes, the market won’treact at all to the forecast error in an economic report that usuallymoves markets. More frequently, the duration of the impact of a forecast error on financial markets may be short-lived. This need not beindicative of an efficient market. Indeed, it often suggests thereverse, especially on days when the initial impact of the economicreport is reversed soon after the report is released.Even when the market interprets the news in forecast errors inthe same way over time, the magnitude of the response to the forecast error may not always vary directly with the size of the forecasterror. Simply put, an extremely large (i.e., rare) forecast error may nothave as much impact as a far smaller (and more frequent) forecasterror. Another anomaly is the market’s differential reaction to preliminary and revised data. Presumably, more accurate data is preferredto less accurate data, yet the market appears to react more to preliminary data than to more accurate revised data. There is a presumptionthat the consensus forecast is rational. Yet, the consensus forecast ofthe news in economic reports may not be rational if market participants fail to take into account seasonal influences, which they frequently fail to do. All of the preceding reasons suggest that the newsin many economic reports is noise rather than fundamental economicinformation. It also suggests that a good economic forecaster may nothave an edge when trading with other market participants.From a trading perspective, whether market participants understand the nuances of economic theory or mistake noise for fundamental economic information is not important. The objective of trading isto make money. It is not to educate other market participants on their
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mistaken beliefs or to correctly predict the outcome of economicreports. Correctly anticipating the forecast error is only part of it.Often, what is more important is correctly anticipating how othermarket participants and the market as a whole are likely to react tothe forecast error or perceived information in an economic report.One important market participant is the Federal Reserve. In manycases, traders use the forecast errors from economic reports as anindicator of likely future Federal Reserve monetary policy actions.How the Federal Reserve responds to the news in the reports maydrive perceived economic relationships among market participants aswell as the responses of the market to economic reports.This means that it is important for traders to not only have a viewon the likely sign and size of the forecast error from an economicreport but also on the market’s reaction to the forecast error. Tradersmust also be able to anticipate how the market will interpret the forecast error. Traders must anticipate the sign, magnitude, and durationof the market’s response to a forecast error. As a result, there isanother risk that must be considered when trading off of economicreports—the risk of how the market will react to the forecast error.Financial markets not only respond to the news in key economicreports; they frequently but not always overreact to it. This creates anopportunity for traders to bet on economic reports after they havebeen released.There is a more general trading lesson that arises from trading offof perceived fundamentals: that the correlation between economicvariables may be transitory. That is, the relationship among assetsneed not be the same over time. Indeed, correlation among financialand commodity markets is often transitory due to misguided notionsof economic relationships such as the BOB (beans over bonds) spreaddiscussed in Chapter 5, “Weather and Natural Disasters.” As will beseen in a later chapter, correlation can be unstable, especially duringmarket crises, and can cause diversified bets to become undiversified.
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TRADING CATALYSTS
Trading off of the apparent news in economic reports is tantamount to gambling if the trader doesn’t have a view on the likely forecast error and the market’s likely reaction to it. However, even if onechooses not to trade on the outcomes of economic reports, the market’s reaction to the reports may provide valuable information in placing other trades. How a market responds or reacts to news may beinformative in itself. For instance, a muted reaction to seeminglybearish news may signal a future rally, whereas a muted reaction toseemingly bullish news may signal a future break.It is worth repeating that the principal objective of trading is tomake money. Whether economic reports contain fundamental economic information or noise is largely irrelevant. Economic reportsand announcements are likely to continue to serve as significant trading catalysts in financial and commodity markets. The large pricechanges and increased volatility that they induce create attractivetrading opportunities as well as substantial risks for traders.
ReferencesBalduzzi, P., E.J. Elton, and T.C. Green. “Economic News and theYield Curve: Evidence from the U.S. Treasury Market.” Journal ofFinancial and Quantitative Analysis, Volume 36, 2001, pp. 523-543.Berry, John M. “Trade Deficit Data Revised Downward.” The Washington Post, April 17, 1987.Black, F. “Noise.” Journal of Finance, Volume 41 (3), July 1986, pp.528-550.Chicago Sun-Times. “Stocks, Dollar Take Tumble as Gold Leaps.”April 15, 1987.Clark, T.D., D.H. Joines, and G.M. Philips. “Social Security Payments, Money Supply Announcements, and Interest Rates.” Journalof Monetary Economics, Volume 22, pp. 257-78, 1988.
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Cornell, Bradford. “Money Supply Announcements and InterestRates: Another View.” Journal of Business, Volume 56, (1), 1983,pp. 1-23.Dow Jones News Service. “US Trade Deficit Stood at Record $18.04Billion in July.” August 29, 1986.Dow Jones News Service. “Fed Reconsidering System of WeeklyMoney Supply Reports.” April 2, 1981.Ederington, L.H., and J.H. Lee. “How Markets Process InformationNews Releases and Volatility.” Journal of Finance, Volume 48, 1993,pp. 1161-1191.Ederington, L.H., and J.H. Lee. “The Short-Run Dynamics of thePrice Adjustment to New Information.” Journal of Financial andQuantitative Analysis, Volume 30, pp. 117-134.Fleming, M.J., and E.M. Remolona. “What Moves the Bond Market?” Economic Policy Review, Federal Reserve Bank of New York,1997, Volume 3, Issue 4, pp. 31-50.Herman, Tom, and Edward P. Foldessy. “Bond Prices Rise SlightlyAmid Rumors About Forthcoming Reports on Economy.” The WallStreet Journal, August 29, 1986.Herman, Tom. “Interest Rates Surge, Stock Prices Fall 51.71 Points;Rumor About Trade-Deficit Report Batters Market—Some TreasuryBond Quotes Plunge Over 1 3/4 Points; Fed Funds Rate Rises.” TheWall Street Journal, April 13, 1987.Herman, Tom, and Alexandra Peers. “Bond Prices End Lower inErratic Day; Fears About the Dollar, Inflation Persist.” The WallStreet Journal, April 15, 1987.The Journal Record. “Dollar Mixed, Gold Jumps by More Than $5 anOunce.” August 29, 1986.Kadlec, Daniel. “Dollar, Trade Deficit Fears Clobber.” USA Today,April 14, 1987.
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Lyons, Richard K., and Martin D. Evans. “Order Flow and ExchangeRate Dynamics.” University of California, Berkeley, January 19, 2001.Mackenzie, Michael. “Treasurys Close Higher Amid ContinuedDeflation Talk.” Dow Jones Business News, September 4, 2003.Maidenhead, H.J., Credit Markets. “Treasury Bill Rates Plunge.” TheNew York Times, August 30, 1986.Morris, Bailey. “Dollar Suffers as US Deficit Soars to Record 18 Billion Dollars.” The Times, August 30, 1986.The New York Times. “Did Wall Street Receive a Tip?” August 31,1986.Newton, Maxwell. “US Notebook: Reality Behind Wealth: MarketEffects of the US Trade Deficit.” The Times, September 1, 1986.Quint, Michael, Credit Markets. “Rate-Cut Hopes Are Growing.”The New York Times, September 2, 1986.The San Francisco Chronicle. “Trade Report Sends Dollar into Skid.”August 30, 1986.The Wall Street Journal. “Bond Marts: Surge in Money SupplyGrowth.” April 13, 1981.The Washington Post. “Rumors of Leak Discounted.” August 30,1986.Webb, Robert. Macroeconomic Information and Financial Trading.Oxford: Blackwell Publishers, 1994.
Endnotes1
The reported number includes the cost of transporting and insuring the goodsacquired. At the time, the Department of Commerce was required by law to separately report the merchandise trade balance including transportation and insurance and 48 hours later release the trade deficit without taking into accounttransportation and insurance costs. On April 16, 1987, the Department of Commerce reported that the merchandise trade deficit for February 1987 was $13.65billion or $1.4 billion less when the cost of insuring and transporting foreign
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223
goods to the United States was excluded. For more information on the monthlyrevision, see “Trade Deficit Data Revised Downward,” by John M. Berry, in theApril 17, 1987 issue of The Washington Post.2
Tom Herman and Alexandra Peers. “Bond Prices End Lower in Erratic Day;Fears About the Dollar, Inflation Persist.” The Wall Street Journal, April 15,1987.
3
Chicago Sun-Times. “Stocks, Dollar Take Tumble as Gold Leaps.” April 15,1987.
4
Tom Herman. The Wall Street Journal. “Interest Rates Surge, Stock Prices Fall51.71 Points; Rumor About Trade-Deficit Report Batters Market—Some Treasury Bond Quotes Plunge Over 1 3/4 Points; Fed Funds Rate Rises.” April 13,1987. The article notes that the 1 3/4 point decline in the long bond brought thecumulative decline in the preceding two weeks to 8 3/4 points for an increase inyield of 87 basis points for the long bond.
5
Daniel Kadlec. “Dollar, Trade Deficit Fears Clobber.” USA Today, April 14,1987.
6
Dow Jones News Service. “US Trade Deficit Stood at Record $18.04 Billion inJuly.” August 29, 1986.
7
Bailey Morris. “Dollar Suffers as US Deficit Soars to Record 18 Billion Dollars.”The Times, August 30, 1986.
8
The San Francisco Chronicle. “Trade Report Sends Dollar into Skid.” August 30,1986.
9
Maxwell Newton. “US Notebook: Reality Behind Wealth: Market Effects of theUS Trade Deficit.” The Times, September 1, 1986.
10
H.J. Maidenhead, Credit Markets. “Treasury Bill Rates Plunge.” The New YorkTimes, August 30, 1986. The article gives a sense of the magnitude of the impactby noting that the yield on three-month Treasury bills fell by 12 basis points bythe close of trading, whereas the prices of the on-the-run 10-year Treasury noteand 30-year Treasury bond rose by 25/32 and 19/32, respectively.
11
The Department of Commerce did not find evidence of a leak and argued thatthe rumor hit the street on Tuesday morning before the trade deficit numberwas even compiled. The Washington Post. “Rumors of Leak Discounted.”August 30, 1986.
12
Tom Herman and Edward P. Foldessy. “Bond Prices Rise Slightly Amid RumorsAbout Forthcoming Reports on Economy.” The Wall Street Journal, August 29,1986. The article reports:Bond prices wound up with small gains yesterday, after wide swings earlier in the day amid a flurry of rumors about economic reports to beissued today and next week. Some actively traded Treasury bonds roseabout 1/4 point, or $2.50 for each $1,000 face amount. At one point…these issues were up about 3/4 point.
13
The Journal Record. “Dollar Mixed, Gold Jumps by More Than $5 an Ounce.”August 29, 1986.
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TRADING CATALYSTS
14
Michael Quint, Credit Markets. “Rate-Cut Hopes Are Growing.” The New YorkTimes, September 2, 1986. The article states:…for the time being many traders are focusing on the trade deficit as alitmus test for the economy and Federal Reserve policy.“If you are trying to anticipate the Fed’s next move, you want to look atthe economy like they do,” said one Treasury note trader who asked notto be identified, “and the July F.O.M.C. meeting showed they are focusing intently on the trade sector.”“If they eased in July, the fact that the trade deficit is even larger nowsuggests they will ease again,” the trader said.
15
For example, see L.H. Ederington and J.H. Lee. “How Markets Process Information News Releases and Volatility.” Journal of Finance, Volume 48, 1993, pp.1161-1191; and L.H. Ederington and J.H. Lee, “The Short-Run Dynamics of thePrice Adjustment to New Information,” Journal of Financial and QuantitativeAnalysis, Volume 30, pp. 117-134. Also see Robert I. Webb, MacroeconomicInformation and Financial Trading, Oxford: Blackwell Publishers, 1994.
16
For example, see M.J. Fleming and E.M. Remolona. “What Moves the BondMarket?” Economic Policy Review, Federal Reserve Bank of New York, 1997,Volume 3, Issue 4, pp. 31-50; or P. Balduzzi, E.J. Elton, and T.C. Green, “Economic News and the Yield Curve: Evidence from the U.S. Treasury Market.”Journal of Financial and Quantitative Analysis, Volume 36, 2001, pp. 523-543.
17
T.D. Clark, D.H. Joines, and G.M. Philips. “Social Security Payments, MoneySupply Announcements, and Interest Rates.” Journal of Monetary Economics,Volume 22, pp. 257-78, 1988.
18
The Wall Street Journal. “Bond Marts: Surge in Money Supply Growth.” April13, 1981. The article goes on to note that some observers thought that the bondmarket “overreacted” to the news because of large transfers from savingsaccounts into checking accounts.
19
Tom Herman and Edward P. Foldessy. “Bond Prices Rise Slightly Amid Rumorsabout Forthcoming Reports on Economy.” The Wall Street Journal, August 29,1986. The article notes:The credit markets showed little reaction late yesterday to a Fed reportshowing another unexpectedly large increase in the nation’s moneysupply.
20
Dow Jones News Service