Tuesday, May 14, 2013

Hoax offers taste of nearing capital rush from risk

A hacked Associated Press Tweet drove jittery capital back to Asia
Without warning, all financial market prices crashed precipitously. Within two minutes, the Dow Jones Industrial Average collapsed close to 150 points. Then, just as quickly, the Dow erased most of the losses. Was this a sign of what may yet come? That all financial markets are interconnected became clearly evident on Tuesday the 23rd. At 1:08 PM.
Launch AP Twitter
Apparently, a hoax by hackers commandeering the Associated Press' official Twitter account had spooked the markets. The fake Tweet alerted of two explosions inside the White House and that the President had been hurt. In an instant, every financial instrument crashed. Futures, Options, Equities and Bonds delivered pain to their investors; all markets but one. Interestingly, currencies responded in a distinctive and insightful way.
When capital moves between two countries, currency prices show the flow's intensity and direction. After the Euro remained absolutely stable during the crash while the Japanese Yen skyrocketed, there was no doubt of the unusually large capital flows escaping our market. The US Dollar chart graphs price fluctuations from the instant US markets were crashing. As capital exited towards Japan, demand for the Yen increased and Yen prices moved higher. The relative difference between the Yen and all other currencies was not subtle, highlighting the impact of this currency. A second chart of the Japanese Yen further shows the strong gravitational force that this currency exerted over many global currencies. Flows back to Japan were just huge.
After the crash, the media debated the impact that black boxes had on price swings. High frequency traders had left their finger prints all over the now familiar flash-crash. But perhaps the question shouldn't be who was behind the trading but what were they trading with? I am referring to the type of capital being deployed. Where does it come from? Is it patient or risk intolerant?
In his fantastic book Unintended Consequences, Edward Conard makes a compelling argument about the difference between two types of capital. There is risk-tolerant equity that does a great job underwriting risk. Then there is risk-adverse capital which demands instant liquidity at the first sign of risk.
Edward Conard
If Mr. Conard is right, intolerant capital entering US markets would first inflate low-risk asset prices. Johnson and Johnson's stock would move higher, for example. Finally, any sign of risk would trigger rapid liquidation as intolerant capital flees the US. Yes, the coincidences are eerie.
Treasury Bills would see unusual demand, no matter how dysfunctional our government may be. Then, as the Federal Reserve crowds out bond buyers through quantitative easing, intolerant capital would be forced to migrate to riskier assets. There would be robust demand for high-dividend stable company stocks;
To prevent such capital flights, the Fed needs to reconsider quantitative easing. The cost/benefit analysis of the situation seems asymmetrical. There is close to a trillion dollars of unused money parked at the Federal Reserve. Long term capital investment has never recovered from the recession's collapse. Quantitative easing is simply not doing too well. On the other hand, it is forcing intolerant capital to underwrite risk; driving stock and bond prices higher without a corresponding increase in patient equity. This is unsustainable.
I may not be into debating haute ├ęconomie with the scholars at the Fed. Nonetheless, I can easily see that there is jittery capital being deployed. I agree with Mr. Conard that in order to ensure full economic potential, we need to create the equity that can underwrite the risk that intolerant capital can't.
This is at the core of the transformation that will make us a great nation for the next hundred years. Government as well as the whole nation need to unite once again behind entrepreneurs and those willing to take risks. We have gone too far with our drive to force people to contribute their "fair share". It is coming across as punishment for success and it is hurting our future. 

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