This is an article very kindly sent to us by Andrew McKillop which we hope you find both interesting and informative.
IT HAPPENED BEFORE - SORT OF
In a detailed paper on why "flash crashes" are now hard-wired into the financial system, Andrei A. Kirilenko of the US CFTC and Andrew W. Lo of MIT ("Moore's Law versus Murphy's Law", copy available at: http://ssrn.com/abstract=2235963) make this comment: 'Arbitrage trading is as old as financial markets. In 585 BC, the famous mathematician and inventor of meteorology, Thales of Miletos cornered the olive oil market by buying or renting all the oil presses after having forecast a good harvest of olives'. In that way, Thales was able to prevent a crash in oil prices, to his own major benefit. Today, he would not have to waste his time playing around with physical oil presses, but would use algorithms, also like meteorologists today, to identify and exploit arbitrage-trading opportunities.
Acting much faster, in fact literally at the speed of light, today's Thales can initiate and communicate their orders, and have them executed anywhere on the planet with the biggest gains going to the fastest players. Naturally or inevitably, some market participants will choose to run a "race to the bottom", taking all possible short cuts, notably by cutting risk controls which slow down order entry and execution. Spread over the system, greater profits accrue to the fastest market participants taking the highest risks, and this, as the two authors of the above paper conclude, can become a source of major risk to the stability and resilience of the entire financial system.
High risk is in particular generated then communicated to the "speculative space" of traders, bankers and brokers through so-called "contrarian trading strategies" - very simply betting against any existing or imputed major trend currently operating. As the two above authors show in a quick review of the 2007-2008 crisis phase for Wall Street hedge funds, and earlier outlyers like the 1998 Long Term Capital Management fund's crash (http://en.wikipedia.org/wiki/Long-Term_Capital_Management), the role of contrarian trading bets in "pulling down the temple" was high. In 1998, LTCM claimed it was using trading models that took advantage of fixed income arbitrage (termed convergence trades), operated mainly on the underlying asset of US, Japanese, and European government bonds. In fact, it had moved out and away from this type of lower-risk trading, to "aggressive contrarian bets", for example bets on whether or not major corporate merger deals would take place.
Called the "Unwind Hypothesis" by the two above authors, the 2007-2008 crisis sequence ended by driving as many as 800 Wall Street speculative funds out of business. Initial losses made by one "contrarian better" were almost instantly transmitted to other players operating different, supposedly very low risk portfolio strategies. Forced liquidation of one or more large "market-neutral" portfolio funds, primarily to raise cash or to reduce leverage, and the impact of this on underlying asset prices, created a shockwave of "unwinding" across the speculative traded asset prices. What starts among the rotten apples, soon transmits to the good apples. With modern high-speed algorithm-based arbitrage trading, this becomes a Flash Crash, as funds deleverage or unwind under panic conditions. Most of all, the experience since 2007 the two authors say, shows there are major underlying similarities between apparently market-neutral hedge funds, using algorithm-based electronic trading, and the risk-on contrarian poker players: the common factor is they both need abundant market liquidity.
ENTER THE WORLD'S CENTRAL BANKS
As we know, gold bullion prices are no longer a sure bet for easy gains. The 2001-2011 decade of constant and effortless increase of the gold price, may be over. To be sure, an awful lot of contrarian bets are at this moment being placed on the contrarian option that gold prices will start growing again.
Joining these contrarian players, we now have almost every single central bank on earth. Central banks as a group have been net buyers of gold bullion for at least two years now. But the 2012 data shows that the amount of tonnage being added is breaking records. Based on current incomplete data from sources such as the WGC, the net increase in central bank gold buying for 2012 was at least 14.8 million Troy ounces, or about 460 tonnes, some 17% of world total "fresh mine output" in 2012.
This figure of 460 tonnes is likely a major underestimate, notably due to "stealth buying" by several very big players including China's central bank. Other very large buyers include Russia's central bank.
The message from central banks is clear: they expect the dollar to move inexorably lower. It doesn't matter that it is itself showing "contrarian strength", for easily described reasons, and has been holding up against other currencies. Central banks are buying gold in record amounts because they see a significant shift coming for the status and strength of the US dollar, and they need to protect themselves against that risk. As Evgeny Fedorov, a high-ranking member of Putin's United Russia Party, said in a recent interview: "The more gold a country has, the more sovereignty it will have if there's a cataclysm with the dollar, the euro, the pound, or any other reserve currency."
To be sure, if the central banks got their contrarian bet wrong, this will produce contrarian results for their declared expectations and their strategy: gold prices will fall, the US dollar will strengthen. Also in play and directly related to the Flash Crash menace, this central bank gold-buying spree has important impacts on global liquidity, by reducing it. Much more radical, and increasingly admitted in "coded language" by members of the Obama administration and influential board members of the USA's regional Reserve Banks, the global central bank gold buying strategy assumes the US dollar cannot and will not survive the ongoing abuse heaped on it by QE and like many or most other currencies will lose a significant amount of purchasing power. In other words the return of inflation via the devaluation of the dollar and all other major currencies.
THE INFLATION BET
In recent articles by myself, and in a consistent if small number of other current and recent articles by economists and commentators, the case for deflation becoming entrenched, and powerful, is not able to be dismissed out of hand.
In its monthly outlook publication 'FX Global Viewpoint' for Sept 2010, Goldman Sachs forecast that "after a brief spike" the USD could only depreciate against "a large number of currencies" despite only little trade-weighted appreciation of these latter. This Viewpoint said it believed "most countries will see their exchange rate against most key trading partners barely unchanged". For Goldman Sachs this would be mainly due to expectations that all non-dollar currencies would appreciate together, at the same time, against the USD. The euro for example would rise to about $1.35. In Sept 2010, regularly repeated, Goldman said this would happen "within 6 to 12 months". Maybe right, some day!
Continuing with this "historical advice" of late 2010 from Goldman, its analysts claimed the basic driver of the process (they wrongly forecast) was the US economy's sluggish growth at substantially below trend rates. In 2010 GS said this was a semipermanent process, almost sine die, certainly lasting to end-2012. Other wrongly diagnosed causes of the GS wrong forecast of a falling dollar against other world moneys, especially the euro, included persistent high unemployment causing a large output gap, low household savings, increasing US imports and rising monthly trade gaps, higher taxes in the US, renewed QE by Ben Bernanke, and so on.
Any of these can be compared and contrasted with what is happening in Europe. Asking for the US dollar to depreciate against the euro is at present like asking for Lady Gaga to replace Pope Francis!
Nevertheless, this is exactly what is needed for the "Elite Theory of Inflation" to not be science fiction. Until and unless the dollar is made to depreciate or devalue against other leading moneys, gold will remain a shaky asset for expecting fast, effortless speculative gains and will remain a contrarian bet.
Using "fundamental talk", the elite fantasy theory requires Decoupling to be real and possible. Under this false theory the US economy can quietly implode and contract - but the rest of the world will power ahead. However, the belief, or fairy story that the world economy can decouple from the US, and the opposite, is false. China is a mirror of US monetary policy, and its economy is tight linked. A slowdown in the US economy drives down China, which in turn puts the brakes on Japan, Australia and Brazil, and all other "China derivative countries".
Under current and emerging conditions, the euro could or might fall below $1.20 and even parity might not be impossible. For the world's central banks, a context where there is Global Coupling and the global economy deteriorates "isotropically" or everywhere, at an accelerating pace but not led by a contracting US economy, this will wrongfoot or "spook" their strategy calling for global inflation driven by a falling dollar. For gold bullion this will be a disaster scenario because the only marginal buyers would be the US Fed and other central banks. For as long as they kept on buying, this would also have major negative impacts on global liquidity.
This is deflation and this reinforces the US dollar.
Any sizeable and sustained flight away from gold to the dollar and decline in global inflation will have negative impacts on liquidity available to market participants, for example simply due to a trend for rising interest rates in non-dollar countries confronted by dollar appreciation and de facto depreciation of their moneys. More important for creating the basis for a Flash Crash decline of vulnerable assets, not only equities but also commodities, the emerging outlook for an end to US dollar weakness, lower gold prices, declining oil and commodity prices, and generalized deflation is the complete opposite of "received wisdom" for speculative players.
Flash crashes or seemingly inexplicable and unexpected, sudden major falls in the market price of almost any tradable asset, from currencies through equities to commodities, are increasingly well known and about the only single common factor - apart from the Moore's Law trading software and IT communications factor - is that liquidity "traps", in a sequence of operations able to only concern a total of 10 seconds but covering millions, or tens of millions of shares, certificates or other supports, create the most important and final "circuit breaker".
Evidently, if there is liquidity shortage on the upstream of the financial chain, this will tend either to prevent Flash Crashes, or intensify those that still operate.
Significantly, this also concerns so-called Bitcoin denominated trading, "Bitcoin" meaning pure electronic money used in a totally unregulated market, the first major case of which occurred in July 2011. http://arstechnica.com/tech-policy/2011/06/bitcoin-price-plummets-on-compromised-exchange/ The most recent "Bitcoin crash" of 12 March 2013 was described by analysts as due to "Cryptographic algorithms gone wild", but the final circuit breaker was liquidity shortage.
Repeated "incidents" on regulated markets (or semi-regulated markets) such as the US Nasdaq, where in milliseconds the price of an asset can fall 12% - 15%, and on equity markets underscore that so-called High Frequency Trading assumes almost unlimited liquidity is available "somewhere". In January 2013 the NYSE slapped Credit Suisse with a large $150 000 fine for "failing to adequately supervise development, deployment and operation of proprietary algorithm, including failure to implement procedures to monitor certain modifications made to algorithm". The $150k fine paid by Credit Suisse was roughly equal to 1.5 seconds of average profit made by its algorithm-based software seeking "remaining value" in equity assets at the end of each day's market trading. Software and human errors resulted in near-complete paralysis of the NYSE for about a half-hour, but no massive and sustained fall of asset values, this time.
The potential for individual users of HFT software abandoning this trading method is therefore very low, showing the systemic market-wide risk of Flash Crash collapse of any asset, requiring very large amounts of liquidity to be available when this concerns a key asset at a key moment. This for example can include European PIIGS debt instruments or even such "iconic assets" as the euro - - or gold.
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