Trading Greenspan , part II

Federal Reserve Chairman Alan Greenspan is perceived as an enigma, a man whose message is cloaked behind a wall of obtuse language. The markets spend an inordinate amount of time trying to break down that wall, hoping they might at last find the Holy Grail on Greenspanisms. But for most, understanding Greenspan to the point where both he and the Fed are even semipredictable, and hence, tradable, is an elusive challenge. Greenspan is

therefore seen as a distraction to investors who would rather focus on companies and industry fundamentals than monetary policy. But Greenspan’s influence is too powerful to be ignored, so investors must labor over his every word.

Is Greenspan, in fact, unhittable—throwing the markets curveballs when they are looking fastball, or is he telegraphing his pitches first? I, for one, fully believe that he reveals his pitches so that anyone, including you, can pick them up before he delivers them. When you look closely, Greenspan, and the Fed in general, are surprisingly open and their predictability far less daunting than legend has it. In fact, the Fed sometimes strains to signal their intentions before they act. Why they do this is clear (this may come as a shock to some of you):they are on our side. Incredibly, this is as forgotten as a trip to the dentist.

Don’t fight the Fed; follow them

The old adage, “don’t fight the Fed,” is Wall Street lore. History is strewn with periods where the performance of both the stock and bond markets was significantly impacted by Fed policy (2000 is the most recent example). Along the way, many investors have either profited from or been harmed by the Fed during these periods, depending upon the degree of respect these investors showed toward the Fed’s influence. It is astonishing to think about how often the Fed is sometimes ignored. This ignorance is usually the result of excess optimism—as was seen in the midst of the Fed’s most recent rate hikes—or excess pessimism—as seen in 1994 toward the end of the Fed’s last rate-hike cycle. Basically, the market sometimes can’t see past its own emotions, but it almost always comes around.

One important insight into Trading Greenspan can be gleamed by looking at the bond market’s historical behavior in the aftermath of the Humphrey- Hawkins testimonies that Greenspan has delivered twice yearly to Congress. These testimonies, which are mandated by law, require the Fed to give their view on monetary policy and the economy to Congress. The detail to which Greenspan describes the Fed’s sentiments almost always pushes him into sensitive topics and this spurs sharp reactions in the markets. The below table illustrates these reactions and provides insight into just how you might consider Trading Greenspan in the future.

	Bond Futures ( 32's )		Eurodollars Futures (tiks)		Next Closest Eurodollars
Testimony	February	July	February	July	Febuary	July
1993	+7	-5	Unch	-3	-3	-10
1994	+14	-31	Unch	-9	Unch	-16
1995	+30	-58	+7	-5	+8	-8
1996	-68	+43	-13	+4	-13	+6
1997	-55	+40	-6	+3	-12	+7
1998	-29	+18	-2	Unch	-9	Unch
1999	-29	-34	-3	-8	-4	-9
Averages :
( Absolut changes )	33/32	33/32	4.4bps	4.6bps	7bps	8bps

As the table shows, sharp reactions have generally followed Greenspan’s initial testimony (Greenspan appears before both the House and Senate—usually just a few days apart—but the text of his speeches on both days is the same, as is required by law). The table shows that the front-month bond contract has averaged an absolute change of 33/32 on the first day of Greenspan’s testimony.

That there have been sharp reactions should not be too surprising. But what stands out, and what is the most tradable, is the follow-through; the market usually continues to move in the same direction as it did on the first day of testimony and the cumulative reaction is usually double that of the initial reaction. It goes on: one month later, the reaction nearly doubles again (also in the same direction).

Ostensibly, the reaction is so sharp because the market believes that what it hears from Greenspan is an unmistakable reflection of the Fed’s policy leaning.And since Fed policy doesn’t change on a dime, the market’s reaction generally continues for weeks on end. Therefore, the next time Greenspan delivers a Humphrey-Hawkins speech, or any other policy speech for that matter, reflect upon what he said (read his entire speech!) and gauge your response. If the market trades sharply higher or lower following a Greenspan speech, place a trade in the same direction of that reaction and wait for follow-through. Give it at least one week. Reassess after one week but keep in mind that the markets’ move can generally go on for at least a few weeks.

Employing the use of both eurodollars and U.S. Treasuries has been a successful approach toward profiting from this volatility. It is important, however, to choose the area of the curve that appears to be attracting momentum traders

(usually the long-bond, but this spec flow is increasingly shifting to 5-and 10-year T-notes). Also consider long straddles and strangles on bond futures. Although both tend to richen in price (due to increases in implied volatility) ahead of Greenspan’s testimony, the ensuing volatility usually sustains much of the richness.

Of course, since the stock market pays particularly close attention to the bond market, similar reactions can be anticipated there, too, especially in the interest rate-sensitive groups such as financials and consumer cyclicals.

By Tony Crescenzi

TradingMarkets.com

Trading Greenspan , part II

In my first lesson, “Trading Greenspan, Part I," I described the best way to trade Greenspan during the two months when he delivers his Humphrey-Hawkins testimony. But what about the other ten months? The first step is to recognize that when Greenspan delivers a policy speech, the impact can span several months. As I said before, this is because Fed policy doesn’t change on a dime. Thus, once the Fed’s policies become clear, the markets behave as though they assume that these policies will be in place for a while. Your trading strategies, therefore, should evolve around the notion that Fed pronouncements have lasting impact.

But how can we decipher where Fed policy stands on a regular basis? I suggest you become a regular Fed watcher. Get in their shadows, in other words. Being a Fed watcher is actually quite simple. What it boils down to is merely tracking the verbiage spewed by the FOMC—that cast of 13,including Greenspan, who vote on whether to raise or lower interest rates at FOMC meetings (held eight times per year). There are five additional Federal Reserve officials who attend the Fed’s meetings, but they vote only every other year (they are in essence the proverbial flies-on-the-wall at the FOMC meetings). While their views matter, too, keep your focus on the voting members.

To get you comfortable with Fed watching, think about it this way: let’s say that you’ve been asked to solve a mystery where all the principal players are known; they talk all the time; you get a plethora of clues about what they’re thinking; they give you verbatim transcripts of what they say; and they give you the minutes from all of their policy meetings. I’ll bet you can crack that mystery in a jiffy. Seen in this light, Fed watching looks pretty well-defined and far less intimidating than most perceive it.

One of the things that I often tell people to do, and that I find many top investors already do, is to read the text of the Fed’s speeches. It is not all that laborious since most speeches are just a few pages long. Reading their speeches gives you far greater insight than if you simply read headlines from newswires that largely reflect a reporter’s subjective view about the speeches.

I strongly believe that no investor should leave it up to reporters to tell them what they should be thinking about what the Fed said; it is up to you. It is perilous to leave it in the hands of reporters, who often have very little background on the financial markets and, quite frankly, can be novices. Do the work yourself and you will find a dramatic improvement in your mastery over the state of Fed policy.

What should you look for when you are reading the text? I look for key phrases that are repeated in lockstep by several Fed members. When I see a particular phrase used either verbatim or nearly so by a few members, I always sense that the phrase is a representation of current Fed policy. When this happens, I envision Fed members meeting with each other, either in person or by telephone conference, drawing conclusions about where they stand on policy.

This then finds its way into their public comments. Of course, all Fed members have their own personal views that they freely express, but this helps us in the battle to interpret the Fed’s public comments. How? Basically, if there’s consistency in the use of phraseology by members known to have bipolar views on monetary policy (just as a democrat and republican would on the issue of tax cuts), then their joint use of a particular phrase is generally a strong indication of agreement over where the Fed stands on a particular issue.

Last year, for example, just before the Fed began its most recent rate hike cycle, several Fed members repeatedly used the phrase, “the balance of risks have shifted (toward higher inflation).” Their common use of this phrase told me that the Fed was in the midst of formulating a new policy designed to counter those risks. This, of course, meant that rate hikes were on the way and they did indeed follow.

It is always striking to me to think that if I simply follow the words of a handful of people (the Fed), I can gain insights that I believe give me an edge on millions of investors. That is why I always include the Fed in my required readings.

Greenspan the Chameleon

Now that I have given you insights into Trading Greenspan, there is one last thing to keep in mind: Greenspan is a chameleon. He changes his stripes all the time. He has savoir-faire—he knows the right thing to do at the right time. Dogma toward policies that can get quickly outdated or outmoded doesn’t bog him down. One minute he is the champion of a particular economic model, the next he scraps it. Greenspan has an indelible record in this regard and it has served both he and the American economy well. You need simply avoid getting mired in the belief that you have Greenspan all figured out.

Greenspan’s views, you see, evolve with the times.

The best example of this, of course, was his recent near-total abandonment of the traditional view that strong economic growth leads to inflation. This critical shift gave him the presence of mind to “permit” the economy to grow at an average rate of more than 4% over the past four years, a rate long considered to be well above the 2.5% speed limit that the Fed has historically used as their guide in the formulation of monetary policy.

Greenspan deftly saw that things were indeed different this time. He sensed that the implementation of new technology and innovations had changed the rules of the game. Greenspan, therefore, became more tolerant of strong growth than his past record would have led you to believe. Incredibly, Greenspan saw that the current period might be, as he called it, a “once-in-a-century period of innovation.” Once-in-a-century indeed. That’s an appellation that belongs to Greenspan.