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HFT vs. the Eurozone Slump

Europe buys a third of world exports. No amount of HFT or Algo trading can beat that fact...

FOR MOST of its history, trading in equities was fairly straightforward on Wall Street, writes Gary Dorsch, editor of the Global Money Trends newsletter.

Buyers and sellers would gather on the stock-exchange floor, and haggle until they struck a deal. Computerized trading didn't arrive on Wall Street scene until the 1980s. Computer guided "Program trading" – defined by the NYSE as an order to buy or sell 15 stocks or more, valued at over $1 million total – was then blamed for the "Black Monday" Crash of October 1987.

Then, in 1998, the internet opened up markets to anyone with a desktop computer and a trading idea. Since then, computer trading programs have grown vastly more powerful and the algorithms that guide their trading vastly more sophisticated.

As such, the average PC trader is no longer able to compete with Wall Street's computers. Powerful algorithms, called "Algos" in industry parlance, scan dozens of public and private marketplaces simultaneously and execute millions of orders a second. Algorithms can spot trends in the global markets, evaluate and integrate the latest news releases, and change orders and strategies within milliseconds, before PC investors can blink.

As the use of algorithms moves from hedge funds and Wall Street trading desks to mutual- and pension-fund managers, these computer guided trades now account for roughly 60% to 70% of total volumes on the NYSE, Nasdaq, and electronic markets, known as Dark Pools. As a result, many banks and brokerage firms have been able to slash their trading desks' staff in half, while more than doubling their equity trading volume.

There's a special class of algorithmic trading, called "high-frequency trading" (HFT), in which computers buy and sell equities based on information that is received electronically, before human traders are capable of processing it. HFT operates in the shadows, often in quiet places located far from Wall Street, and trading stocks at warp speed. These computerized traders move millions of shares around in minutes, yet only seeking to profit by "scalping" a few pennies off each share.

Over the past few years, high speed traders have deployed algorithms more widely, and have become bigger players in commodity futures, foreign currencies, international stocks, and exchange traded funds. According to the Chicago Mercantile Exchange, roughly 35% of all commodity futures trades is now handled by high speed computerized traders. That figure is expected to reach 60% of commodities trading volumes in the years ahead.

Now, with so many moving parts in the global financial markets moving at faster and faster speeds, it's no wonder that commodity fund managers are increasingly turning to Algos. Today, HFT and other computer-generated trades account for 35% of the volume in Nymex energy futures. Even longer-term macro traders, who hold positions for weeks or months, are turning to Algos to collect and analyze a wide range of data, such as interest rates, employment numbers, purchasing managers' statistics, Chinese oil imports, corporate earnings, global GDP figures and so on, at millisecond speeds. Algos can read and evaluate hundreds of economic indicators at any moment in time, before firing off a trade.

How can the average investor hope to outsmart an Algo trader? Fortunately, computerized trading is mostly used in scalping operations, providing massive liquidity to the markets, but isn't altering the market's longer term mega-trends. In fact, Algos appear to be utilizing traditional tools that have been used for decades, and are in sync with today's "financialization" of the commodity markets.

That is to say, Algos are reinforcing the "inter-market" relationships between currencies, interest rates, global equity markets, and the commodities sector – most notably, metals and crude oil.

Such was the case over the past year, when the gyrations of the Eurozone's equity indices, and the Euro's exchange rate against the US Dollar were key drivers influencing the price of North Sea Brent crude oil.

Since peaking in mid-March, the exchange traded fund for the Eurozone's broad stock market index (NYSE ticker: EZU) has fallen sharply, from as high as $32.50 per share to around $25 today. EZU has suffered a "double whammy", including the Euro's 10% slide against the Dollar. Thus, EZU is a key Algo indicator for crude oil traders, since it tracks the Eurozone equity markets – a real time barometer of the market's outlook for the Euro-zone's economy – and it also incorporates the Euro's exchange rate. In turn, EZU's slide to $25 per share, has weighed heavily on Brent's tumble to below $100 per barrel.

Two other key variables that should be analyzed, are:

  1. the amount of crude oil that's supplied by Saudi Arabia and the Opec cartel; and
  2. the direction of the Euro versus the Dollar.

Although its influence has waned over the past few decades, the Saudi royal family is still the chief central banker of the crude oil market, and is the swing producer of the Opec cartel. Riyadh says it has 2.5 million barrels per day (bpd) of spare capacity that can be pumped into the market at a moment's notice, to either cap prices or knock prices lower. It's interesting to note, that the peak in the North Sea Brent crude oil market, at $127 per barrel, did coincide with a stern warning from Saudi Arabia's oil chief, Ali al Naimi.

Writing a rare opinion piece in the Financial Times on March 28, Naimi blasted "irrationally high oil prices," saying there was no shortage of supply, and that Riyadh was ready to use its spare production capacity "to supply the oil market with any additional required volumes.

"Supply is not the problem, and it has not been a problem in the recent past. There is no rational reason why oil prices are continuing to remain at these high levels [$127 per barrel]. I hope by speaking out on the issue that our intentions – and capabilities – are clear. We want to see reasonable crude oil prices. Saudi Arabia will do what it can to mitigate prices. The bottom line is that Saudi Arabia would like to see a lower price."

Earlier, Naimi identified $100 a barrel as an ideal price for producers and consumers. To make this happen, Saudi Arabia boosted its oil output over the next few months to a record 10.1 million bpd, and lifted Opec's combined oil output to 31.8 million bpd in April – or 1.8 million above Opec's stated quota, thus greasing the skids under North Sea Brent.

On May 8, Naimi first indicated that the Saudi kingdom was pumping 10 million bpd and was also storing 80 million barrels to meet any sudden disruption in supplies.

"In addition to our spare capacity of 2.5 million barrels per day, we have on the ground, in tanks and in pipelines, about 80 million barrels of inventory. These are working inventory," Naimi said.

Following Naimi's initial warning, the price of North Sea Brent tumbled $40 per barrel lower to $88 per barrel in June, before rebounding to around $100 today. Coinciding with crude oil's slide to below $100 was a slide in the Euro's value from as high as $1.34 in early March to as low as $1.2350 in late May. Traders reckon that Riyadh would try to put a floor under North Sea Brent at around $84 per barrel, which is the estimated "break-even" point, that's necessary for Riyadh to finance is domestic spending programs. But the Euro's sharp slide against the US Dollar has been a thorn in the side of the commodity markets for the past 14 months.

The Continuous Commodity Index (CCI) measures a basket of 17 equally-weighted commodities. It stumbled into bear market territory on June 20, soon after the Federal Reserve balked at launching a third round of quantitative easing (QE3) in the United States. The CCI fell as much as 27% from last year's high, when it skidded to the 500-level, its lowest since November 2010. In turn, the Euro's slide from as high as $1.4850 in April '11 to $1.2150 today, a drop of 18%, was a major catalyst behind the CCI's demise.

The Euro also fell to record lows against the "commodity currencies" of the Australian and New Zealand Dollars, after the ECB lowered it repo lending rate to a record low of 0.75% on July 5.

Traders expect more ECB rate cuts and another injection of cheap, long-term loans (LTRO) for banks. The Euro also fell to a 3.5-year low against the British Pound and a 10-year low against the Chinese Yuan on July 9. The People's Bank of China (PBoC) responded by lowering its 1-year loan rate within minutes of the ECB's rate cut, but failed to stop the Euro's slide versus the Yuan.

Europe is the world's biggest buyer of goods and services, buying 31% of all global exports. However, with the Euro losing its purchasing power against most major currencies, European consumers could be forced to cutback on purchases of foreign imports. Unemployment in the Eurozone reached a post-unification record of 11.1% in May – a full 1% higher than in April 2010, and also denting consumer spending.

The jobless rate is likely to climb higher in the coming months, as depression like conditions in the peripheral Euro-nations spreads to the core. Manufacturing in kingpin Germany, is already showing signs of stagnation. Latin America's biggest economy – Brazil – has already seen its export sales of iron ore, ethanol, cocoa, sugar, and other commodities begin to slump.

The recession in Europe and a sharp slowdown in top commodity-consumer China has resulted in a big shrinkage in Brazil's trade surplus, cut in half to $7.1 billion in the first six month of 2012 compared with a year ago. That marked the weakest surplus for that period in a decade.

Brazil posted a trade surplus of US$807 million in June, down from $2.95 billion in May and far below the $4.43 billion surplus in June of last year – the smallest monthly trade surplus for June since 2002. Brazil's economy – the world's sixth-largest economy – has decelerated significantly over the past 1.5 years. It grew a stellar 7.5% in 2010, its fastest pace in over two decades, but slowed sharply to 2.7% last year as the Bank of Brazil lifted its overnight Selic rate to 12.5%, in order combat an overheating inflation rate.

Brazil's economy has now been stagnant during the first half of 2012, and it is showing signs of slipping into a outright recession. Brazil's industrial output fell for a third straight month in May, falling 0.9%, and output was 4.3% lower than a year earlier, the largest annual decline since a 7.6% drop in Sept 2009.

Brazil's factory sector continued to slump in June. The purchasing managers' index (PMI) for Brazil's factory sector dropped to an eight-month low of 48.5 from 49.3 in May. Brazilian retail sales fell 0.8%in May as Brazilians struggle with rising defaults, which are reaching an all-time high, and in turn, are prompting local banks to tighten lending.

In an effort to stabilize the economy, the Bank of Brazil slashed its Selic rate 50-basis points (0.50%) to a record low of 8% on July 11 amid a barrage of other stimulus measures. So far, a deluge of interest rate cuts, tax breaks, and tens of billions of Brazil reals in subsidized loans, and targeted state spending, hasn't enabled Brazil's economy to regain its mojo.

It's an ominous sign that Latin America's largest economy is no longer an engine of growth for the world economy. As such, currency traders have dumped Brazil's Real, knocking it to around 49 US cents this week, compared with 64.5¢ a year ago. The Real is a victim of the year long slide in commodities, itself suffering the fall-out from Europe, which account for half of Brazil's total exports. Brazil's exports fell to $19.35 billion in June, or 18% lower than a year earlier. No amount of computerized high frequency trading can reverse that.

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GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

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