Friday, August 24, 2007

FT's Lex forgets: investors drool too

The credit hullabaloo is toppling many perceived truths. Triple-A means safe, for example. And terrified investors rush into gold. If there was ever a time for gold to demonstrate its safe-haven status, it was Monday. Yields on three-month Treasury bills plummeted almost 200 basis points as investors scrambled for government paper. Surely, this dramatic flight to quality should have pushed gold through the roof. Yet the price of gold did not shift from exactly $657 per troy ounce from Friday to Tuesday.

Either all bullion traders holiday together or investors prefer to trust the US government with their money more than they do gold. That is not as silly as it sounds. Gold is, after all, just a metal, and sentiment can be as irrational as for a high-risk asset. It is not even scarce. Nearly all the gold ever mined is still above ground. Only about 10 per cent of 2007 demand is for industrial use, whereas three-quarters of demand is for jewellery. It also provides no yield – although the way Treasuries are moving, that may not be a relative disadvantage for long
. FT

Many readers are likely familiar with the experiments of Pavlov with dogs. Pavlov would ring a bell each time the dogs were fed and then he found that the dogs would salivate (drool) after hearing the bell even when they weren't fed.

One feature of the black boxes used to make trading decisions is to make those traders like Pavlov's dogs. They have no sense of fundamentals, like if they are getting fed (i.e. buying low), but simply react blindly to stimuli. Investors have bought US bonds during the past few crisis, therefore, Pavlov's dogs are sure these are the things to buy.

This process is aided by timely intervention with this effect in mind.

Further experimentation by Pavlov showed that the dogs eventually stopped drooling after a period of just hearing the bell without getting fed.

I suspect the conditioned reaction to financial crisis will also wear off. Meanwhile, I advise one to think twice when hearing a bell.


Fullcarry said...

Credit contractions are by definiton bullish for the currency that is contracting. Money (currency?) is bid up as leveraged accounts sell assets to make margin calls. All else being equal supply of money goes down.

But that is the whole point. All else is never equal and it is hard to imagine that dollar demand will hold up as this crisis unfolds.

I can't imagine this subprime fiasco is making people more gungho in transferring their savings into dollars.