Financial markets operate on the edge of chaos. If prices moved in easily predictable patterns, traders would make money by jumping in front of them. But that would disrupt the pattern, making it useless for prediction. On the other hand, if financial markets were pure noise, there would be no point in investing. Asset prices would drift randomly back and forth, completely unmoored from any fundamentals. Instead, we see an equilibrium where a weak signal, driven by fundamentals, struggles against waves of noise washing over it. In the short term, the noise dominates. Longer-term, we can discern the signal if our tools are powerful enough.
Last week presented a great illustration of this dynamic. A series of US economic data announcements surprised on the upside: retail sales jumped the most in 10 years, new unemployment benefit claims fell, hiring picked up pace, and factory output accelerated. Usually, a stronger economy leads to an increase in interest rates and a drop in bond prices as demand for credit grows in an expanding economy. But this time, the bond market reacted in the opposite way: rates fell, and prices rose.
To quote the Financial Times, “bond investors are bewildered” reminding me of Agatha Christie’s crime novels where Scotland Yard is baffled until Hercule Poirot arrives on the scene and unbaffles them. Regrettably, bond market analysts are no Poirots, and investors remain bewildered. None of the proffered explanations make much sense. Claims that the reflation trade got too crowded, hedge funds started unwinding their shorts, or that banks were adding to hedges against expected debt issuance are hard to confirm in the data.
It is more fruitful to accept that the chaotic market, as is its won’t, threw some noise in the works, and it is a waste of time to try to divine the reasons behind every price swing. Better to return to our time-tested tools and let the longer-term trends guide us. In hindsight, we may discover that last week was a great turning point of the reflation trade or, au contraire, it was a mere blip. But we don’t need to fret about it now. Our trading system will tell us what to do in either case.
Last week’s continuing trends:
- European Wheat
- US Real Estate
- Canola
- Taiwanese Equities
- Corn
Last week’s reversing trends:
- Lean Hogs
- Dollar Index
- The Euro
- Canadian Interest Rates