Friday, 4th June 2021
ASX 200 Index (XJO)
This week we note the YMAX ETF, which is a substitute for the XJO, has generated multiple Distribution signals. All of the conditions are present for the XJO to terminate this rally and move lower, yet the market continued higher this week.
A large part of this is explained below in the Algorithm Trading section. The dominance of the robots in a market that has little participation with the general public is an example of how far the programs can take markets. Low volume is a sign that the market is exhausted.
Too much liquidity?
In the banking world, the Central bank offers a facility called the Repurchase Agreement (Repo). Normally, when banks require cash they will lodge bonds with the Fed in return for cash. The next day the bank will buy the bonds back for a fee from the Feds and this allows orderly conduct in the banking system.
There is a Reverse Repo facility that is used by banks when they have too much cash and want to get paid for lending it to the Fed overnight. This reverse Repo normally spikes at the end of quarters as the banks square up for reporting purposes. In the past week, this Reverse Repo has spiked to record levels as shown in the chart below.
What this is telling us is that the financial system is drowning in liquidity, with so much cash struggling to find a home. This has forced the Fed’s Effective Fund Rate to hit 0.06%. If it continues, this number will turn negative very quickly.
What it also signals is that the Quantitative Easing program that the Fed is conducting has reached a limit. The purchase of bonds every month, but then having to sell the bonds in the Reverse Repo is financial lunacy. This is the financial system telling the Fed to stop the QE program and let the market sort out the imbalances.
Lately, the market has seen a large amount of trading being done via Algorithmic Trading programs, with some estimating that over 50% of daily turnover on the ASX is done via a computer. These programs are so common in America that some of the big brokers allow open source on coding with financial rewards for the programmer who delivers the most profitable program.
What is algorithmic trading?
Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions which account for variables such as time, price, and volume. This type of trading attempts to leverage the speed and resources of computers, compared to human traders.
Algorithmic trading has been gaining traction with both retail and institutional traders. It is widely used by investment banks, pension funds, mutual funds and hedge funds as they may need to spread out the execution of a larger order or perform trades too fast for human traders to react to. A study in 2019 showed that around 92% of trading in the Forex market was performed by trading algorithms rather than humans. [Link to article].
Algo’s, or automated trading systems, encompass a variety of trading strategies, some of which are based on formulas and results from mathematical finance. They often require specialised software to run.
Why do people use algorithmic trading programs?
Timesaving: Algo’s can be programmed to run 24-hours a day, 7 days a week.
Emotionless trading: As the program is completely automated there is no human emotion involved.