Streetwise Professor

March 25, 2012

Bullbusters, Part 2

Filed under: Derivatives,Economics,Energy,Financial crisis,Financial Crisis II,Military — The Professor @ 8:43 pm

An UNCTAD paper by David Bicchetti and Nicolas Maystre analyzing high frequency data from commodity futures markets has received a tremendous amount of attention in the few days since its release. The paper purports to present evidence that high frequency trading has distorted commodity prices, hence the flurry of attention to what is in fact a rather unexceptional paper.  Indeed, the only thing exceptional about it is the authors’ extreme over-interpretation and sensationalization of the results, and their failure to consider seriously more reasonable interpretations of their findings.  Their characterization of their findings borders on academic malpractice, and raises questions about their sincerity.

The empirics are rather straightforward.  Bicchetti and Maystre calculate rolling correlations between EMini S&P 500 futures returns and the returns on 6 commodity futures contracts-WTI, corn, soybean, wheat, sugar, and live cattle.  These correlations are calculated at various frequencies ranging from 1 second to 1 hour.

They find that correlations were typically around zero before jumping substantially around September, 2008. Based on this, they conclude that “the financialization of commodity markets has an impact on the price determination process.  . . . In fact, the strong correlations between different commodities and the S&P 500 at very big frequency are really unlikely to reflect economic fundamentals.”  They further claim that “HFT strategies, in particular the trend-following ones, are playing a role.”

Their basis for this claim is extremely thin.  They note that HFT trading has become increasingly important in recent years.  They note that correlations jumped in 2008.  They conclude that the former caused the latter.


Gee, now what happened in September, 2008?  Let me think.  Think. Think. Think. Oh, I remember now-we had a financial crisis!

Could that maybe explain the change in correlations?

Damn right, it could-and did.  First, note that the correlations between the S&P 500 and commodity prices are going to be driven primarily by whether supply or demand shocks are driving commodity prices.  Take oil as an example.  When supply shocks are important, one would expect zero or even negative correlations between oil prices and stock prices.  An adverse oil supply shock should lead to higher oil prices and lower stock prices.

When demand shocks predominate, however, positive correlations are to be expected.  Adverse aggregate shocks depress both oil prices and stock prices.

Thus, correlations depend on the composition of shocks.  When demand shocks (driven by shocks to income) predominate, correlations should be positive; when commodity-specific supply shocks predominate, correlations should be zero or negative.  (With the ags, since supply shocks are unlikely to be correlated with aggregate income or growth, one would expect near-zero correlations.  With oil, supply shocks can have macro effects, so negative correlations can arise.)

Starting in the fall of 2008 there was a dramatic increase in the flow of information about demand-related shocks.  The predominant feature of those months was a dizzying flow of macroeconomic-related news.  Would major economies be thrown into depression? Would the financial sector collapse?  Would economies recover?  How rapid would the recovery be? What were governments doing to trying to stem the collapse and rekindle growth?  The composition of economic shocks shifted decisively towards demand/income-related shocks that dwarfed commodity-specific supply-related shocks.

In this environment, commodity-specific supply-related information was swamped by systematic demand-related information.  You would expect-clearly-this to lead to positive co-movements between stock prices and commodity prices, because both were being driven by demand related information.

Moreover, financial shocks during the crises that  constrained risk-bearing capacity that were quite prevalent during this period would have affected both stocks and commodities, and in the same way.  These shocks to risk bearing capacity would have affected expected returns on commodities and equities in the same way.  This would have also contributed to substantial positive covariation.

The very discontinuity in the correlations around the time of Lehman supports this view.  Algorithmic trading and HFT trading (they are different) were both growing throughout the mid-to-late-2000s.  There was no discontinuous jump in the utilization of these strategies at the time of Lehman.  But there was a discontinuous jump in the correlations.  A much more plausible interpretation of the data is that a discontinuous change in the nature of economic shocks (becoming predominately economy-wide demand-related shocks) and correlated shocks to risk bearing capacity (that led to correlated shocks in expected returns) attributable to the (discontinuous) financial crisis explains the discontinuous change in correlations.  The authors offer no plausible explanation-none-of how a continuous growth in HFT could lead to a discontinuous jump in correlations precisely in September, 2008.

Indeed, their measure of HFT-the ratio of volumes to trades-flattened out precisely during this period, after having fallen since the beginning of 2007.  If this is a measure of HFT, it should have jumped down discontinuously at the time correlations jumped up if in fact HFT was driving correlatons.  But the exact opposite happened.  The authors let this obvious problem with their interpretation pass in silence.  This is inexcusable.

There is other information in the report that strongly supports the view that fundamentals were in fact driving the correlations.  In particular, the WTI-S&P correlation dropped substantially in January-April, 2011.  This is precisely the period in which the Arab Spring and in particular the outbreak of civil war in Libya led to substantial supply shocks in the oil market.  As noted above, supply shocks for oil should lead to opposite movements in oil prices and stock prices.  An increase in the flow of supply-related information should lead to lower correlations between stock and oil prices.  The Arab Spring and Libyan events led precisely to such an upsurge in supply shocks, and correlations fell exactly as would be expected if fundamentals were actually driving prices.  Under the HFT interpretation, there would have had to have been a drop in HFT utilization during this period, which certainly did not occur.

In sum, the evidence presented in the widely hyped Bicchetti-Maystre paper in fact strongly supports the view that fundamentals were driving commodity and stock prices during the sample period.  In particular, the main piece of evidence that B-M emphasize-the jump of correlations in September, 2008-corresponds to an obvious regime change in which economy-wide shocks that would affect both stock prices and the demand for commodities occurred more frequently and with greater severity.  One would predict-and in fact I did so predict contemporaneously-that such a change would lead to a substantial change in the correlations between stock and commodity prices. (I made this prediction publicly at a symposium held at the Bauer College shortly after the beginning of the crisis, and actually made the conditional prediction in the summer of 2008 that the only thing that would bring down oil prices was a serious economic downturn.)  The change in oil-stock price correlations around the time of the Libyan crisis is also consistent with the hypothesis that price movements reflected information about fundamental supply and demand conditions.

In contrast, there were no discontinuous changes in “financialization” or the utilization of HFT either in September, 2008 or during the Arab Spring/Libyan period.

In sum, the actual evidence presented in the paper strongly supports the hypothesis that fundamentals drive prices.  It does not provide any support for the hypothesis that “financialization” or HFT is distorting prices and overriding the impact of fundamentals.  Indeed, there is strongly contrary evidence.

Thus, although the empirical analysis in this paper is unobjectionable, the interpretation is contrary to the actual results and a reasonable reading of the economic and financial history of this period.  Indeed, the interpretation is so at odds with the data and history that the motives of the authors are open to serious question.  They jump on the anti-financialization, anti-HFT bandwagon even though (a) the actual data does not support that interpretation, and (b) other, quite opposed, interpretations are much more reasonable. Whenever there is a yawning gap between the most reasonable interpretation of an empirical analysis, and the interpretation that the authors advance, one may reasonably question the intellectual honesty of those interpretations.

And I do so question.

I therefore recommend examining the various graphs presented in the paper in light of an understanding of how the composition of economic shocks should affect correlations, and an understanding of what was happening during the sample period of the study.  I further recommend completely disregarding the Bicchetti-Maystre interpretation of their results, because it betrays no understanding of either the economics or the history.

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  1. As a person who traded those markets, I will say that in 2008, most of the cattle volume was on the floor, not the screen. In 2009, the Lean Hogs made the jump to the screen. In 2010, the cattle made the jump.

    The Lean Hogs trade very different now that they are on the screen than when they were in the pit. While more volume trades, the bid ask is a lot thinner. I like to say that the marginal volatility at any one point in time is greater now than when it was in the pit. I also notice that the market doesn’t track the cash market as much. The cut out price might be tanking (cash), but the futures price pays no attention. That could be because it’s a future-but it might also have something to do with algos.

    The intercommodity spread prices and trade bear no resemblance to how it traded before it went on the screen.

    Other studies I have seen talk about stocks. The equity market is a different animal. HFT certainly has had effects on the futures markets. At first, it just put independent traders out of business.

    Comment by Jeff — March 26, 2012 @ 5:49 am

  2. Once a market goes electronic you are clearly going to get a load more fund money investing in it. The price is then the honest price, because it’s no longer being front-run by a bunch of bent locals who think a tick is $10.

    @ Professor – I reckon in a few years’ time there will be fewer HFTs, not more and not the same, because they will outcompete each other and because their existence lessens arbitrage and hence their profits. Would you agree and if so has this been observed before?

    Comment by Green as Grass — March 26, 2012 @ 9:18 am

  3. I don’t think that the point is that HFT trading did or did not change the way trading in a single commodity or the commodity complex as a whole, but whether one can say that HFT has caused a correlation across different markets in and of itself. Rather that the correlations that may exist between seemingly radically different markets is a function of overall fundamental factors.
    As these factors change the correlations will reverse or strengthen. In other words HFT is in and of itself not the issue.

    The reason this hypothesis is so readily accepted is that it fits the political narrative of the bien pensant class: Evil speculators are causing all our problems!! The people who use HFT techniques (Hedge funds) are behind it! This is a new variation on a very old theme adding, in the words of Poo Bah “to add verisimilitude to an otherwise bald and improbable tale”
    sorry about that, just been listening to The Mikado.

    Way back when (1978-9) there were a lot of guys who were trading gold vs stocks on a negative correlation – Long gold short non commodity stocks, or the reverse position. Despite some hiccups, generally worked out until Jan 1980 to March, when the correlation when positive big time (both tanked, with their levered Gold positions leading the way) and they all went broke or fled. What kind of shock did we have them, the collapse of the Hunt brothers Silver corner and 15% Treasuries. Seemed a reasoned response to the fundamental at the time.

    The current reality is that the system is choking on money – are we surprised that financial and physical assets that have foreign demand or uses (e.g. not domestic housing) are rising at the same time?

    Comment by sotos — March 26, 2012 @ 9:32 am

  4. Seems to me like the debate about how to interpret the correlations reported by Tang and Xiong in their recent paper on commodities and financialization. Main difference is the time scale. At least Tang and Xiong tried to condition in some way on an identifiable aspect of financialization: the rise of index fund investment. I did not see where the UNCTAD paper did something comparable.

    Comment by Scott Irwin — March 26, 2012 @ 10:30 am

  5. SWP, you are giving Bicchetti and Maystre academic credit by defeating their analysis critically. They don’t deserve your thoughtful criticism for such a kindergarten paper. Why not skewer their malpractice from a public-choice perspective? The authors are clearly looking to advance their careers with a sensational paper pushing the HFT trading buttons for policy makers. Soon they will be on the speaking tour for “Committee to Save The World”.

    Comment by scott — March 26, 2012 @ 2:09 pm

  6. It reminds of climate science.

    All these speculators buying up the market. Who’s selling to them and why isn’t the selling forcing the price down?

    How do these long-only speculators avoid selling in their turn when they roll?

    Are there any short speculators?

    Comment by Green as Grass — March 26, 2012 @ 6:34 pm

  7. @Scott-That was the motive I privately ascribed to their dishonesty/academic malpractice, but I didn’t verbalize it. But I think you are spot on.

    The ProfessorComment by The Professor — March 26, 2012 @ 8:55 pm

  8. Professor you are the best:

    Comment by street unwise professor — March 27, 2012 @ 9:11 am

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