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Friday, October 1, 2010

Unintended Consequences Galore.....

Well where do I start today? I think I will begin with the report on Reuters today titled “SEC says Flash Crash Report Will Bring Confidence”. In the article they state that regulators expect to issue a report over the next few days that will explain how over 700 points were lopped off the Dow Industrials in minutes. Their belief is that the CTFC and SEC staffs have a deep understanding of what transpired as well as some ideas on going forward; or at least that is the message they want to convey. It appears that the belief is that the “Flash Crash” undermined investor confidence. To some extent it is true that the incident may have been the proverbial straw that broke the camel’s back.

There have been many issues that have transpired prior to the flash crash that have lead investors to believe that the markets are rigged or at least manipulated. How many days over the past decade has the Dow been down 200 plus points and suddenly at 2pm on the dot a buyer shows up in the futures pit buying every S&P futures contract to push the market up; and low and behold the shorts are squeezed and the market cuts its losses or rallies sharply positive.  This combined with the computer trading that utilizes algorithms to shave a penny off of a transaction at the expense of actual traders, know as high frequency trading drives this market. We have gotten to the point where the big houses’ computers are trading against each other and many if not most funds and investors are just cannon fodder on the way to trading profits. The only way to truly instill confidence in the markets would be to eliminate or at least sharply reduce the algorithm based high frequency trading, which in an unexpected circumstance runs amok like the “Flash Crash”. Of course when the trading runs amok to the upside no one would care but that is not what is sapping market confidence. In a second Reuters article titled “Report to say Waddell stoked flash crash –source” , a single trade by a Wadell & Reed trader sparked the now infamous Flash Crash. This is a living example of how high frequency algorithm trading don’t handle non linear events well and then essentially a programmatic short circuit occurs. Yet the SEC and CTFC want the general public to have confidence that they can put in place regulations that can handle unforeseen consequences of traders and algorithms that behave outside the expected norms. Unfortunately, if we are not removing the high frequency trading algorithms we will have to live with the potential of more episodes like this at an unexpected time in the future.

On a completely different topic House lawmakers voted 348 to 79 in favor of putting pressure on China to boost the value of its currency. I find it fascinating that we as the debtor relying on the purchases of the Chinese to fund our profligate spending have the audacity to be making demands. Now that said it is unfair that the Chinese peg their currency for an advantage.

There are those that make the comparison to the Smoot Hawley Act of the great depression, which is a fair comparison. While the Smoot Hawley ACT did not cause the great depression it did lead to a 66% reduction in world trade between 1929 and 1934; more importantly it did nothing to foster trust and cooperation between countries. Today there is a similarity between Smoot Hawley and this recent bill, in that it will not promote trade that we need. In fact there are unintended consequences if this act is actually implemented. As I type this there is inflation in China because we export it to China via sale of treasuries and the US Dollar in general. So if the Yuan, which is China’s currency, is allowed to rise it will be China exporting its inflation back to the US. We as a country get so much of our goods as imports and a statistically significant portion of them come from China. This bill would allow the Chinese to float their currency higher against the Dollar there by making commodities which China needs that are denominated in dollars cheaper for them. On the other side of the pond because the Dollar is weaker Joe Six Pack will see a decrease in his purchasing power. The evidence of this comes since China had earlier adjusted its currency and prices of imports have risen albeit slowly; the result is shown in an article regarding price rises at Walmart. Additionally, US  businesses that use commodities will see further price rises along with consumers of their products due to the weaker dollar.  If at the same time the FED does its QE2 plan the dollar could have a significant decline, which would hurt consumers and businesses but benefit the Government from a debt perspective. The US debt would become more manageable with devalued dollars, but it would be a further beat down on savers and the productive class.

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