How traders avoid saying "I don't know" , and in the case of political risk they REALLY don't know.....

Friday 3rd July 2015

How traders avoid saying "I don't know" , and in the case of political risk they REALLY don't know.....

"Why the probability of Greek Eurozone exit is 99% wrong, probably" , The Financial Times, p.32

The days of the old-fashioned, seat-of-the pants, "gut" traders have long gone, at least amongst the big boys. Leaving aside those who let computer-driven algorithms do the (mainly short-term) trading for them, traders like to make decisions based on historical and statistical analysis. In the case of a high-yield (junk) corporate bond for example, historical data can help to estimate the likelihood of a company defaulting, and statistical data can help to calculate potential losses if it should.

When it comes to political and international events that have no precedent however, such tools are largely redundant. By definition, there is no historical data to fall back on and no amount of contemporary statistical analysis can reliably predict the market effects of a one-off event, or even the likelihood of it happening. Political risk is extremely difficult to price, and therefore becomes a judgement call. Its very unpredictability sits uncomfortably with traders more attuned to eliminating risks than taking them.

Which is why the market practice is to talk in terms of the "probability" of something happening. For example : "There's a 20% chance of the Cow jumping over the Moon", or "There's an 80% chance of Greek Finance Minister Varoufakis being awarded the freedom of Berlin". If an institution estimates the probability of a certain outcome as 50%, I think we can take it as read that what they're really saying is "I don't know", which of course is fair enough though it would be refreshing to hear it put into words ..... dream on ! The more cynical view is that if you give a probability estimate of say 10%, or 90%, and the unexpected happens, you can always say that your number implied that there was a chance that it might.

Anyway, how does all this apply to Greece and Grexit ? In the greater scheme of things , Eurozone markets outside of Greece have behaved with remarkable equanimity during the deepening crisis, which either suggests that they don't care (absolutely not true), or that they are undecided whether Grexit will actually happen and what the effects might be if it does (absolutely true). The Financial Times lists a number of high-profile institutions whose estimates of the probability of Grexit range from 20% to 85%, which really should tell us all we need to know about the level of uncertainty out there.

The simple truth is that nobody knows what's going to happen. Sometimes that's just the way it is, just don't expect too many to say it.

June US employment data making the future for rates any clearer ? Hardly......

"Dollar and Treasury yields fall as US jobs data offer mixed signals", The Financial Times , p.31

On the face of it, yesterday's non-farm payrolls number of +223,00 against a consensus forecast of +230,000 would seem neither here nor there. It was also not deemed significant that the headline unemployment rate fell to 5.3% from 5.5% as this was put down to departures form the labour force. Instead the markets focused mostly on the fact that payrolls numbers for the previous two months were revised downwards by a total of 60,000 , and that hourly earnings were unchanged which suggests that there is still some slack in the labour market.

So on balance the data was taken as "soft", and in its small way reduces the pressure on the Fed to raise rates. As we've discussed many times , market estimates are split with regard to the timing of a hike. It would be fair to say that a majority still favour September over December, but all will be keeping a wary eye on international developments. Theoretically, the Fed's remit is basically a domestic one but inevitably it will take into account the harmful effects of rate rises on the Greek debt crisis.