Wednesday, 20 May 2009

Reflation traders: Playing with the market's own money

I have written previously about what I believe to be a serious problem facing capital markets and which I have called the "double-bind" trading trap. This is where many traders may be faced with a situation in which successfully responding to one message means failing with another and vice versa , so that the unwitting trader will be automatically wrong regardless of his/her response. In simplified terms it could be reduced to saying that the trader is in a no-win situation.

However "smart" traders are learning to use strategies in which they will only benefit from those who fall for such traps on a continuing basis.

Spelling this out a little more in the context of the performance of the markets today (May 20th 2009) there is a conflict between the green shoots narrative necessary for the refinancing of the banks scenario (Bank of America (BAC) sold $10 billion plus in new equity) and the reflation trade.

In order to ensure the success of the re-financing of systemically important banks certain market constituencies are pushing equity indices to key resistance levels based upon the narrative that the worst is behind us in terms of financial meltdown, Armageddon etc.

At the same time, however, other traders are selling the US Dollar, buying commodities and in general engaging in the reflation trade and thereby posing a real problem to the benign inflation scenario upon which the solution to an ever increasing debt/GDP problem is based i.e. manageable long term interest rates.

Increasingly the "double bind traders" are playing the following reflation game.

Long S&P 500, Long Emerging Markets, Long Crude Oil Futures, Long Commodities in general and especially gold and the gold Miners, short the US dollar - especially by being long the commodity currencies - Canadian and Aussie dollar (and to some extent sterling) with a short bias towards Treasuries.

At critical inflection points, primarily detectable from monitoring the spikes in equity indices, the reflation traders will have very profitable positions in the reflation trades and will be able to recycle the profits made from those trades into financing short equity index positions and, after a suitable time delay, going long Treasuries.

Needless to say this trade is eminently repeatable, and the really vicious part of the double bind is that ultimately the reflation traders are playing with the market's own money.

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