Define market (in)efficiency: the Euro

Euro/USD prices: An anomalous move?  Source: thinkorswim by TDAmeritrade

Euro/USD prices: An anomalous move? Source: thinkorswim by TDAmeritrade

The Efficient Market Hypothesis is a well-known, well-respected theory.  It’s frequently cited by folks in the economic & financial space to justify very conventional, buy-and-hold investment products.  Particularly in the stronger forms of EMH, all publicly available information is immediately reflected in asset prices.

I’ve written before about the impact of ‘known unknowns’ versus ‘unknown unknowns’ in financial markets.  The recent crash in the Euro strikes me as an interesting case study:

  • Why is the Euro crashing?  In a term, policy divergence.  The European Central Bank is providing quantitative easing to the Euro-area, which means (all other things equal) higher money supply and a cheaper currency.  In contrast, the Federal Reserve is gradually pulling back from their quantitative easing (i.e. letting their purchased bonds run-off), and thinking about raising interest rates this summer.  Both these actions should mean a stronger US Dollar.
  • Why such a prolonged slide?  This is where I think the markets are interesting.  In an informationally-efficient world, I would have expected a big move at the onset of European QE, with not much happening thereafter (perhaps some oscillation around a new equilibrium level).  Instead, we’re being treated to a managed futures manager’s dream scenario: a fairly steady downward trend, without many pull-backs.
  • Perhaps behaviour economics can answer?  An explanation could be found in the inefficiencies considered by behavioural economics.  Among the possibilities:
    • Discrete decision points: perhaps each business/investor considers the QE announcement at different intervals, and thus make moves in sequence.
    • Loss aversion/disposition effect: folks long Euros have been holding on, while losses pile up.  Over time, they accept their painful losses at different points based upon relative aversion.

In sum: efficient markets shouldn’t really show these kind of smooth trends.  But the trends exist all the same.  Hence it’s worthwhile considering momentum as a viable investment strategy.

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