The current global synchronized bust caught policymakers around the world by surprise because global conditions regarding risk exposure of underlying assets were opaque. According to the Bloomberg New Financial Conditions Index, which measures the average global financial condition, by October, the crisis was nearly 10 standard deviations from the average score of that index. Whether this was a true black swan event or one brought on by incompetence and conflicts of interest in the pricing of new and opaque securities is debatable. But three standard deviations from an average is 99% away from that average, so you can see the seriousness of the calculation. Because of the gap between expectation and reality, the world lost 40% of its worth in 2008.
Many have asked themselves how the true financial conditions could have been misread or ignored. In fact, the best economists at the Federal Reserve recognize that there is an inherent imprecision and latency in information on business conditions, and as a result, active research is moving to create new indicators, such as real-time indexes of fundamental conditions. (See a real-time measurement of business conditions at www.federalreserve.gov). Some are even suggesting tracking Internet commentaries as potential financial indicators. The time when there are accurate non-latent measures of current conditions is still far away. This raises a critical concern: If the best of the best can’t see the forest for the trees, the currency investor and trader may be trapped in a field of expectations that are unfounded. For the currency investor and trader, the challenge therefore is to recognize signs, when expectations that have been driving the market are wrong, as early as possible. The trader that avoids becoming a victim of expectation gaps will have the edge.
Here are some key expectations that are shaping today’s trading opportunities:
1) The economy can be jump-started: The conventional wisdom behind stimulus programs is that economic growth can be manufactured by flooding the economy with dollars. However, the key assumption that consumers will return to previous higher spending habits may be false. The consumer psychology may have permanently shifted and avoiding spending is now the norm. Additionally, the expectation behind a stimulus program is that the recession is a textbook structural recession. It may, however, be a balance sheet recession, where debt reduction and not spending is the major goal of corporations and consumers.
2) U.S. sovereign risk is zero: To date the market has believed in the full faith and credit of the United States. What happens if the U.S. dollar loses its status as the most credit-worthy asset in the world? The idea that the United States could fail would be ridiculous just a few years ago, but fear that the United States could fail to repay its debts does not seem so crazy today.
3) We are in a deflation: The fear of deflation is emerging as the dominant sentiment among central bankers and policy makers. Deflation, defined as the persistent decline in prices, is a phenomenon where expectations reinforce themselves. If consumers expect prices to decline, they will postpone purchases. A recovery in consumer demand will therefore require a revaluation not only in prices, but in expectations. The enormous increases in the money supply could lead to this level, but if central bank actions go too far, they could lead to a significant inflation. What happens if the consensus that inflation is not a problem is wrong? Go back to the second point. America is not likely to fail on its debt, even if it requires printing massive amounts of dollars to do it.
4) The housing market will bottom out and recover: The housing bubble and bust was a surprise to many. The current expectation is that actions such as reducing interest rates to zero and rescuing toxic mortgages will result in a bottoming to the housing market. This expectation may be overstated based on demographics. The key driver of the housing boom was the baby boomer segment of the population. They provided the spending impulse to consumer housing. This applies around the world. Demographic forces, not psychological expectations, project that the baby boomers are declining as a percentage of population and therefore the demand for housing will decline. This is ominous, as policy makers are betting the country on a resurgence in housing just as the demographics are inexorably reducing the demand. In other words, the expectations about housing markets recovering should be received with great caution.
5) A Depression is a real possibility: This negative expectation is beginning to surface. Keep in mind that during the Great Depression gross national product in the United States fell 46% in four years.
We are in a time where expectation management is posing great challenges for policy makers and central banks as well as traders. But traders have the edge because they can play on all expectation scenarios.
Abe Cofnas is the author of “The Forex Trading Course” (Wiley), “The Forex Options Course” (Wiley) and the upcoming book, “Sentiment” (Bloomberg). Reach him at firstname.lastname@example.org