@Aurelija's

It has been a tough week for me. Had to get away from the Markets on Wednesday to enjoy a 48-hour exam in Advanced Macroeconometrics. Pheww, THAT was en exhausting experience, I had already almost forgotten how it is to do those 48-hour take-home exams. I only had 2 of them before, but this third one was a real toughy compared to previous experiences. It is, indeed, intensive 2 days - little sleep, no sports, just coffee, tons of papers and thinking. Friday morning 4am brushing up the final pieces and - upload. The rest of the day the feeling was as if after a great party - dizzy, red eyes, no voice... lack of sleep resulted in me sleeping longer than to 6am on Saturday and Sunday. BUT IT WAS WORTH IT :)

The markets, I see, haven't changed much. The EURUSD, indeed, keeps trending up, now seriously.

Surprising? NOT at all. When everyone is so heavily positioned against EUR it doesn't take much to turn it up. It's not so much about PIIGS now, as everyone got used to the Euro cancer; it's the relative macro to be watched now. The European data, like PMIs, have showed some improvement this week. The US data has also been not bad, but the US economic surprise index has peaked, and apparently the Fed do not see a continuation of the positive news - Fed sounds to be up for more quantitative easing and low rates until 2014, and lower USD rates do not help USD much. Will that continue - the next week is crucial, with the US ISM and non-farm payrolls. If that disappoints then it may be the period of positive surprises from the US is coming to an end. This, if data is not a huge miss, may gradually lift the EURUSD further.

If the "muddling through" continues without big new shocks we are back to 2009 with plentiful liquidity and room for risky asset performance. With the EUR and USD rates stuck at the bottom for at least two years it's difficult to see how the asset managers are not tempted not chase a higher yield anywhere from US equities to Emerging Markets FX. Getting more and more bullish.

A fearless rise of the EUR we have observed in the foregone week.


This, on the one hand, was not surprising at all, given the massive overload in short EUR positions in the markets. It has, indeed, become very tricky to be short EURUSD, as the chances of a short squeeze with such positioning in the market are increasing.

But that left aside, it has not only be technical moves, but also a reflection of the overall market sentiment. The European debt auctions went well, the stock markets increased bolstered by a number of positive news from all over the world - China's positive GDP surprise, US earnings, US weekly jobs numbers...

All in all, the year-to-date risky assets are performing; just looked at a cross asset performance and everything is indeed in the green - from Greek bonds to copper to equities. The VIX keeps trending down and even the CDS of PIIGS countries are off peaks. What is it? Still holiday mood? The harsh fundamentals of the European situation haven't changed over those weeks. But the markets are more positive anyway.

The big elephant in the room, I think, is the European Central Bank, which before Christmas provided ample long term liquidity to the bank sector, thus alleviating the stress in the interbank, seen, among other things, from declining EURUSD cross currency basis. If ECB keeps doing this, and they will likely do, the markets may continue improve if unexpected shocks are absent. Now all the information on euro area problems has been digested - even the Greek default would not surprise anyone (given the pricing of Greek 2Y bonds, it's all in now...). What else could go wrong?

My impression is that the key potential negative shocks to the markets at this point could be non-European. That is, either: 1) US macro news starts to surprise negatively (surprise indicator seems to have peaked); 2) we get a geopolitical conflict of some sort in the Middle East, with the negative oil price shock.

Can the markets remain trend up - the weeks ahead will show. We've got yet another European leaders' meeting on January 30th, and the coming week will be marked by smaller meetings and talk. January 26th when the first Italian long term debt auction takes place will be a lakmus test for the market participants' immunity to European risks.

After a rather uneventful week came Friday 13th. And right in the middle of the day the rumor hit the market on that S&P is about to downgrade a bunch of European sovereigns. Needless to say, the markets switched to the "risk off" mode in no time. Despite of the fact that the downgrade of the euro area economies was far from a "black swan", the EURUSD took a nearly 2-figure hit...


S&P later sent out an official statement:

...Standard & Poor's Ratings Services today completed its review of its ratings on 16 eurozone sovereigns, resulting in downgrades for nine eurozone sovereigns and affirmations of the ratings on seven others.

We have lowered the long-term ratings on Cyprus, Italy, Portugal, and Spain by two notches; lowered the long-term ratings on Austria, France, Malta, the Slovak Republic, and Slovenia, by one notch...

I've never been fond of the rating agencies - they act downright pro-cyclically, always behind the curve, and always come out in the wrong time...But, that aside, I am actually somewhat surprised by their official statement on the action, seeing in it, no less, no more, but an indirect claim that the situation in the euro area is hopeless, and that the only way out is the euro area's breakdown.

Just read the excerpt from their long explanation as to why the ratings were cut:

Today's rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

So, basically, the S&P claims that the whole thing is systemic, and all what Merkozi have been doing recently - all the discussion on fiscal austerity - is the road to nowhere. Interestingly, S&P even states that deleveraging is bad (given the current debt/GDP ratios in the euro zone, huh?!).

I thought I got the point with those 5 points already. But then the S&P made it easier with this much more explicit paragraph below:

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU's core and the so-called "periphery". As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.

In this, S&P, sadly but true, gets the core of the problem out - the euro zone is doomed to failure. It is a wrong construct.

I have myself been thinking a lot about the euro zone's past and future, and the more I do the more convinced I get that the overall idea was wrong. It merged too divergent economies, where Germany served as euro zone's "China" and the southern periphery acted as the euro zone's "US". By "China" and "US" I mean the differences in propensity to save/consume. That is, Germany has been the over-saver economy, channeling its savings to Greece &co which have been willing to use the money to consume beyond their means. And since the big chunk of extra consumption came, guess where from, the over-saver Germany, everyone was happy, enjoying the "gains from trade". Germany grew on exports, Greece&co grew on domestic consumption. Statistics showed nice growth for both.

Yet, as it now turns out, this inter-temporal transfer of wealth was not pure "gains from trade". In fact, it was all illusional gains - as during the past couple of years they have, and for the next several years will be repaying back their "gains from trade". This comes in many formats: higher borrowing costs, recession, lower wages, equity losses in the financial system, no pensions for newer generations... I would not be surprised if eventually the "cost from trade" turns out to be larger than the "gains of trade" we were after when the euro zone was being created.

All in all, my mind has started to question the benefits of free trade which is so well established in our modern academia. All this is just distribution of wealth in time which, when added together, is just a zero sum game.

Apart from the economic wealth, unfortunately, there is also social wealth involved, and this in the coming years will remain a huge problem involving a lot of loss in human capital. This huge youth unemployment we are seeing in the euro zone today is nothing but a result of inter-generational wealth distribution which was, as many people would agree today, not fair. But, unfortunately, when wealth is transferred in time, only those reaping the gains are the actual decision makers.

We are all in this together.

Happy new year.

The first week in the markets was still full of the holiday mood, as many markets people were still on holiday. But in terms of market movements and data the week was nevertheless interesting. In particular, the culmination with the better than expected US job market report. The US labour market is clearly improving and unemployment continues to trend down...


...which is good news. Not only because of the fact itself, but also because of the reaction - the EURUSD fell in reaction!


This is in contrast to many previous positive surprises, where the EURUSD actually increased on the news. The fact that this time USD strengthened could be seen as a sign that the "risk appetite" is no longer a key driver of the USD, which signals less stress in the market. It is the macroeconomic reality that drives the EURUSD - the US is clearly standing on a stronger foot, hence a reflection in its stronger currency. The latter is also confirmed in the interest rate market, where the spread between the EUR and USD interest rates is moving in the USD favour...


Since the first week has not been very "liquid", it still remains to be seen how the year will start in the markets in the coming few weeks. There are some signs, including the macro, that we may get a repetition of 2009, where post-stress rally took off in Q1. Yet it may as well be that the euro area's problems come back with a vengeance hitting the markets with another wave.

Personally, I am up for the first scenario and thus up for refilling my personal portfolio with some US stocks. The only reservation I have, however, that the recent US macro improvement and related positive surprises may come to an end, since the latter was mostly due to the labour market which is, unfortunately, a lagging indicator of economic activity. If one looks at some forward looking indicators like US consumer confidence the picture is not yet consoling.

It has been an extremely busy few months for me - lots of traveling, everywhere from Gdansk in Poland to St. Petersburg in Russia to the polar Tromsø in Norway. And on top of that I had ACI course in November, which I successfully finished earning the Dealer's Diploma with distinction last Friday following a 3-hour exam. After the 3-year CFA saga the ACI 2 levels this year were a walk in the park - yet, still challenging. Moreover, ACI Dealer does not overlap with the CFA heavily, as CFA is more designed for capital markets, while ACI focus is on FX and the money markets.

And that was not all for me this autumn/winter - I also took a course in Advanced macroeconometrics - cointegrated VAR - at Copenhagen University and an exam is pending January. So this beautiful blue book...


...is and for a while will be my "bible". And I truly love it. :) I know other people think I am crazy when they see me reading such stuff (e.g. on a plane), but I find the world of matrices and stochastic processes like a pastime activity, it just stimulates my mind just like running stimulates my body.

I know I am no longer "student" officially, as the master's degree issued nearly two years ago, but I am sure I will be a student all my life. When I watch my colleagues and meet other business people it seems that once people get the jobs many fall into their comfort zones and give up actively seeking new learning opportunities in a couple of years. That's wrong. In order not to get rusty one should seek opportunities to learn, turning the practice into the lifelong learning.

For me the lifelong learning continues. Apart from the vast amounts I learn at work I will continue to pick up the courses, seminars and designations on my way. Not quite decided what designation to take next (CQF or FRM?), but as a next course I have already booked a phd course in advanced continuous time finance in spring 2012. Gotta be fun :)

Apart from the knowledge that can be applied at work another big advantage with studying extra is better time management, I find. My experience shows that when the hands are full the time optimization is more successful, and hence productivity increases. And productivity is the ultimate power (ask Germans).

Behavioral finance has always been one of my interest areas, so when I saw D. Kahneman's new book at Amazon - "Thinking, Fast and Slow" - I had no doubt I had to get and read it asap.

In his new book Kahneman, a father of behavioral finance, explains the concepts of human thinking and behavioral biases in a new light - with examples and scientific evidence. Even to those who have heard/read about behavioral finance before the book offers many "aha" moments. It reveals flaws in our thinking and behavior, the awareness of which could make our lives much easier.

Kahneman distinguishes 2 systems of human thinking - calls it System 1 and System 2. System 1 is our intuitive/quick thinking, and System 2 is the lazy one - it requires more effort and it therefore requires power of will. System 1 is where the major human behavioural flaws are made - the system tries to build coherence, finds explanations to fit our believes, and often oversimplifies.

The law asserts that if there are several ways of achieving the same goal, people will eventually gravitate to the least demanding course of action. In the economy of action, effort is a cost, and the acquisition of skill is driven by the balance of benefits and costs. Laziness is built deep into our nature.

Kahneman discusses many behavioral biases one by one. Key focus on "status quo" and "loss aversion", which is inherent in our nature:

Loss aversion is a powerful conservative force that favors minimal changes from
the status quo in the lives of both institutions and individuals. This
conservatism helps keep us stable in our neighborhood, our marriage, and
our job; it is the gravitational force that holds our life together near the
reference point.

I loved the author's examples with the loss aversion, especially in the context of trading. According to Kahneman, good traders are those who do not suffer from the "endownment effect" (which means not willing to give up something you already own). This is proved by experiments. Good traders do not build emotional links to the financial assets owned and do not stick to their views no matter what. Flexibility is key, and unfortunately the human nature is not endowed with that - this is something one needs to learn consciously.

All in all, lots of relevant issues and good advice from Kahneman in just 1 book. It is definitely not a 1-time read, and the book can find a place in a shelf for many years - as a manual of human behavior.

Yet another week of positive news from the US macro front. The manufacturing activity clearly picks up now and the labour market is improving. All job market reports this week were broadly positive, culminating in Friday's non-farm payrolls, which again showed a decent job growth in November, so that job creation rates are now close to pre-crisis trends...


Most importantly, there were significant upward revisions for the previous months - again - which signals more can be in the pipeline.

Furthermore, unemployment rate fell again, and only half of that fall was due to the changes in labour force.


So, all in all, the US is recovering, and the economy should keep up the 2% growth rate in the coming quarters. Meanwhile, the euro area is entering the contraction phase, and now the question is not whether it falls into recession early next year, but how deep it will be - the estimates range from 0.5% to 2%. The only hope for the euro area is now that global growth keeps up momentum. The divergence between Americas and EU has been confirmed by this week's manufacturing PMIs - clearly activity is falling in the euro area and now dragging together even the Eastern Europe - even Poland and Czech Republic. In the US and Latin America, on the contrary, the activity is improving. If the American economies keep performing, this may help improve European external demand, especially on the back of weakening euro. The American growth will support China, which, in turn, will further keep up imports from the euro area.

But there will be no miracles. One way or another the world will face a slowdown in the coming quarters. It may be even deeper if the financial stress is not resolved. This week's coordinated liquidity provision by the global central banks marked, in my view, the beginning of a new round of quantitative easing. We will see more of this in the form of ECB buying purchasing more and more of the European bonds in the coming months, as nearly EUR 150bn mature in Q1 2012.

This week on the 9th yet another European leaders' meeting. But apart from forcing ECB to buy more bonds no quick solutions to the European problem can result now. Fiscal union? Yes, but it will be very difficult to arrange, given the diversities in the euro area. And even if implemented the project of fiscally united euro area will require that the new rules are implemented, enforced and the old mishaps - such as huge periphery debts - are written down, so that everything could be started from scratch.

In the meantime, investors are on a "wait and see" mode. Whoever I talk to say that they are off risk taking for now and keep the button on buying US Treasuries. So USD still is the ultimate liquidity and reserve currency, worth holding on to in turbulent times. Liquidity is expected to worsen toward the end of the year, which may cause unpredictable moves in the financial markets. Yet I am confident we will soon see more confidence underpinned by, first of all, confidence over the US economy, secondly, by fear to miss the next rally - funds need to deliver and cannot sit on cash forever.