Alchemy, EMH and Richard Clarida

The market participants are constantly glued in to the incoming news. The common but slightly incorrect understanding is that they are trying to decipher what the future going to look like. Forming a view about the future is important but not the cardinal aspect, once the view is formed the grind is to check and test that view with every new bit of information. Deciphering what has been priced in the current price is the alchemy which the participants are trying to perfect.?

Reams of academic literature has been written on it. Eugene Fama's EMH (efficient market hypothesis) propounds that the markets are perfect and all the available information has already been priced in the current rate. This is obviously a depressing conclusion for many because it means that you cant beat the markets by having superior fact finding skills. But there is reprieve as?the strong form of EMH (described above) is an ideal construct. In real world the information is not available to all participants neither instantaneously and nor at once. There is a hierarchy from the ultra smart money at the top and the lazy retail at the bottom which work at different levels. Hence it makes sense to chase data and being first of the blocks (depends on which level you are). There is an informational arbitrage there to be exploited but as the algos take over reading all the machine readable data, the arbitrage is narrowing by the day.

The process is deceptively simple, form a view with all the available information, also factor in the expected values of the upcoming data and then check each data release for the surprise. For example in the current level of rupee the inflows on account of IPO flows has already been discounted. It started getting discounted since the time the IPO dates were announced and got refined everyday as news emerged about the anchor book participation and grey market demand. The actual day of flow is of lesser consequence. The move from 75.50 to 74 happened in anticipation. The surprise would be some news which reverses these flows, a controversy or something similar which has not been priced.

One other aspect of EMH is that market should be deep and liquid with multiple participants. EME currencies generally have a vibrant and liquid profile in good times but during stress periods the liquidity dries out making them prone for large swings. In that aspect markets for US treasuries is the most liquid of all hence it is no surprise that USD is the reserve currency of the world.

As we wrote the CBs have also understood that to achieve their worthy goals of financial market stability, communication is one of the most important tools in their toolkits. Regular communication even if couched in ambiguous wordings is important. YCC control by BOJ, AIT by Fed etc all policy triggers and actions, markets should know in advance and be allowed to form a view. In a discussion yesterday conducted by Brookings Institution, Fed Vice Chair Richard Clarida spoke about the inflation. Lets look at his choice of words, "realized PCE inflation so far this year represents to me much more than a moderate overshoot of our 2 percent longer run inflation objective and I would not consider a repeat performance next year a policy success." Readers should take a 2 minute pause and a deep breath to internalize the statement and decide what to do. To me it reflects a slightly more hawkish view of the lift off and aligns more with current market view of 2 hikes next year compared to FOMC projections where only 3 participants projected more than one hike in 2022 (SEP's in September FOMC). Markets should recalibrate accordingly, short term yields should inch up.

The next CPI data for US will be released tomorrow, the previous reading was 5.6% YOY for the month of September. The event at which Clarida spoke had a detailed discussion around inflation nuances where ECB's Philip Lane and Former Fed Chief Ben Bernanke also spoke. A recommended watch from my side.