Tuesday March 21

Stocks fell today more than 1% ending a long streak and posting the biggest day of losses since the election. The S&P 500 fell 1.2% to 2,344 and the Dow Jones fell 1.1% to 20,668. The KBW Bank index fell 3.9% while utilities fell 1.4%. While the economic calendar was light, investors drew concern over delays to potential Trump policies which sparked the reversal of the Trump trade. Today certain Republicans warned peers that delays to repealing Obamacare could result in delays to pass other fiscal policies such as tax cuts, deregulation, and fiscal stimulus. Those concerns are what sent prices lower today. Esther George spoke and said there is room to remove some stimulus, and Loretta Mester and Eric Rosengren are set to speak later tonight. In addition to financials retail also had a rough day. On that backdrop rates rallied and the dollar weakened. The 2 year Treasury yield fell 2bp to 1.26%. The 10 year Treasury yield lost 4bp to 2.42%. Accordingly 2yr vs 10yr bull flattened to 1.16%. The dollar weakened against peers as well. USD fell 0.6% against EUR to $1.0814 even as Emmanuel Macron won a debate against Marine Le Pen. USD fell 0.8% against JPY to Y111.66. USD fell 1.1% against GBP after economic data showed that inflation rose more than estimated in the region. Gold prices had a strong day rising 0.9%. Oil prices dropped with WTI falling 1.5% and Brent falling 1.4% to $47.5 and $50.91 respectively.

High frequency trading firms are confronted with a difficult industry environment that is bringing down earnings significantly. In 2009 it is expected that HFT companies earned $7.2bn trading US stocks, however last year that had shrunk to just $1.1bn. Since 2009 industry revenues have been down significantly and they have been below $2bn since 2012. The sharp decline in revenues also coincides with a drop in the VIX, however a decrease in revenues could also be more closely tied to trading volumes as well. That comes as high levels of competition and higher costs are driving down returns. That could help explain why Virtu last week sought to acquire KCG. While Both Virtu and KCG are involved in HFT, KCG also has a market making division so Virtu wanted to diversify its businesses. Virtu’s stock has lost around 25% since IPOing in 2015 so it may be looking to find support from investors through inorganic growth. Other companies such as Interactive Brokers Group and Teza Technologies have said that they are exiting high frequency trading activities as well. These companies may move into market making or other activities such as ETF arbitrage. Higher costs such as constantly upgrading hardware and upgrading to microwave networks also is eating into the profitability of the business. Market data and co-location costs from the exchanges are also rising as their presence and effectiveness has become more widely known. HFT company Wolverine Trading commented that market data costs have tripled since 2008. The NYSE and Nasdaq have defended their pricing in spite of complaints from the HFT industry. Other structural flaws involving dark pools have dried up as dark pool operators have started using faster connections and preventing the presence of HFT in their pools.

Relevant inflation numbers are showing that investors and consumers both expect inflation will stay around the Fed’s target over the next 5-10 years. Data on Friday showed that consumers expect inflation to average 2.2% over the next five years and 2.5% over the next ten years. In markets the five and ten year breakeven rates are both 2% and 2.01% respectively which suggests that traders aren’t concerned about a run in inflation if the Fed takes a more dovish tone. If the 10 year breakeven was higher than the 5 year than that would reflect expectations that inflation might run hot at some point. Both of those estimates are higher than current CPI levels which came in at 2.7% most recently. The Fed’s preferred measure of inflation the PCE index was 1.9% most recently. That could suggest that investors are anticipating inflation to moderate after the effects of higher oil prices are phased out later this year. In spite of the idea that markets aren’t pricing in any significant inflationary worries, demand for TIPS has been strong which shows that investors still want to adjust for the changing tides in markets. ETFs that track TIPS have received a total of $5.3bn in inflows this year.

So-called “portfolio-insurance” funds are a cause of concern for some market analysts. “Risk mitigation” or “crisis risk offset” or similarly called investment strategies are used as portfolio hedges or insurance policies in times of distress in markets. They trade strictly based off of momentum signals, so when markets are falling these CTA (commodity trading advisor) funds sell into the market to earn a profit. They are computer-driven strategies and they have amassed nearly $300bn in assets and have been on a rising trend significantly. CTA funds were the only hedge funds to receive inflows in 2016 and they performed well in the 2008 financial crisis and at the start of the year last year. Pension funds allocate to CTA funds to hedge the rest of their portfolios and Calpers recently put in $16bn into “risk mitigation strategies”. Typically large institutional investors such as Calpers put around 10 – 20% of their assets into those strategies. However the downside is that they have been blamed for intensifying market turbulence and losses in times of distress. They are largely blamed for Black Monday in 1987 when stock prices dropped 20% in a day. Making matters worse, ETFs and other products have been coming up which make similar strategies and are more accessible to investors. However they do not tweak their models enough so they are static, which critics argue makes them less effective. Additionally the effects of leverage magnify the effects of these strategies which can have a sizeable affect on markets even though the assets in the funds aren’t too big of a portion of the total market.

Tuesday March 21

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