More and more international financial markets have been moving in tandem. Assets around the world are flowing in the same directions at the same time. This makes it harder to pick individuals stocks for out-performance. It also means that macroeconomics is more important for determining future asset values of individual securities, commodities or currencies. The markets continue to move in interesting ways internationally and are worthy of deeper study.

Algorithmic Trading

Over the past two decades, algorithmic trading has supplanted humans as the largest market participant. Computers are now filling orders in well over half of the trades in stocks, commodities, and currencies, with bond markets closely following.

These programs spot correlations between assets all around the world and immediate hedge or arbitrage gaps in pricing when they appear. Now, companies or currencies never trade too far from the norm because a computer program will quickly pick it up and start trading against the outlier. This has the effect of making all trading trend toward “beta” expected performance in line with the overall indexes. Out-performance or “alpha” is much more difficult when computers close the good trades so quickly.

Additionally, algorithmic programs are executing trades in milliseconds. They use the fastest technology with servers located right at the exchange. That means they are able to anticipate flows in the market better and trade against them. That reduces wild swings and the ability to make outsized profits. However, if there is truly a wave going in one direction, algorithmic traders do not provide deep liquidity to the market and may have to follow the trend which could exacerbate the problem.

Central Banks

The role of central banks around the world has grown enormously since the financial crisis in 2008. Today, the Federal Reserve has about $3 trillion worth of government securities on its balance sheet. Any expansion or contraction of this number shakes the market substantially. That is in addition to the important role of setting interest rates that they have always held.

The Bank Of Japan, the Swiss Central Bank, the European Central Bank and the People’s Bank of China actually even have a greater influence on their country’s economies. They are actively keeping interest rates low, inflating the economy with bad debt, buying stocks and indirectly allocating capital to wasteful infrastructure projects with unlimited funds. This has created a tidal wave of excess liquidity that is still jostling markets.

Risk On/Risk Off

Due to the role of computer trading and central banks, the last few years have seen a general “risk on, risk off” trade where all kinds of different assets that are considered risky or safe move in tandem with one another.  For example, the US dollar, Treasury Bonds and the largest Dow stocks are all considered safe assets. Emerging market debt, emerging market currencies, micro-cap stocks, and commodities are all considered riskier and tend to lose value during those periods. Interestingly, “risk on, risk off” trades can swing from day to day or continue over months. That makes the market even more difficult to predict.

It is difficult to see what would end this type of trade except for a giant retreat of central banks from the market. This would either precipitate a crisis or take such a long time that it is not worth considering over the short or medium term. Investors should be careful about either possibility and continue to monitor the public statements of central bankers.

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