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Just a few dozen bona fide traders make their living in the global macro hedge fund world. They manage a $400 billion slice of the $2 trillion total hedge fund pie. I have probably met half of them.

Few global macro managers are purely top-down traders. They employ some strategists and economists who think top-down, but global macro traders rarely work from 30,000 feet. They usually begin as specialist tacticians in markets like nonferrous metals, oil or Treasuries. If they survive, they trade more assets, more currencies and more “crosses” over time, learning how to profitably handle a complex global macro portfolio. Most of their trading ideas come from the bottom up in a couple of the segments they know well, idiosyncratically mixed with broad themes that they have developed. But several times every day, they carefully check the portfolio of these trades against their views of the macro world for consistency and for risk management purposes — what some call their reference scenario.

As I described in a March article in Institutional Investor, I started exploring the global macro world back in 2005, when the Central Intelligence Agency gave me an informal license to hunt for intelligence insights among macro traders. We thought Washington could learn a lot from the care with which global macro traders built and monitored their reference scenarios, because they have powerful incentives to get it right and lots of money to construct sophisticated early-warning systems. In that article I totted up the political decisions that move these reference scenarios, speculated about which government actions that move markets were becoming more or less opaque (or transparent) from a trading perspective and flagged some methods that smart traders use to get an early-warning jump on these events — or at least avoid being crushed by them.

In April, I helped convene a two-day conference at Ditchley Park in Oxfordshire, England, that combined two dozen traders with a motley crew of former policy wonks, spies and scholars. From those freewheeling and off-the-record discussions, a key reference scenario emerged, which I subsequently refined and retested with the traders.

I found that the reference scenario most broadly held by global macro traders turns on just four key events: U.S. monetary policy, Chinese GDP growth, the European Union sovereign debt crisis and the price of oil. Other uncertainties seize their attention from time to time — Tokyo’s ability to contain the fallout from the Fukushima Daiichi nuclear power plants, the giant traffic jam as thousands of trucks full of Brazilian soybeans fight their way down a single highway to the port of Santos, and Vladimir Putin and Dmitry Medvedev’s shadowboxing over who runs Gazprom and who inherits the Kremlin — but the traders are watching the Big Four like red-tailed hawks. And they have placed their multibillion-dollar bets on the likely outcomes.

These four concerns are critical for the Federal Reserve right now too. At his landmark April 27 press conference, Fed chairman Ben Bernanke admitted that these big-picture events were the major source of uncertainty in the Federal Open Market Committee’s forecasts: “I can say, without too much fear of giving away the secret, that FOMC participants do see quite a bit of uncertainty in the world going forward. And a lot of that uncertainty is coming from global factors. I have already talked about Middle Eastern–North Africa developments, which have affected oil prices, and conditions in emerging markets, which have affected commodity prices and other things. The European situation continues, and we’re watching that very carefully.” Bernanke diplomatically avoided mentioning that sharp disagreement among his Fed colleagues is part of the fourth big event: monetary policy.

In addition to traders and the Fed, a lot of people care about reference scenarios. The business and financial media are awash in them. Every investment bank and asset management firm has its own reference scenario du jour, which the chief investment officer or senior analyst describes in Davos-speak in the top few paragraphs of the weekly, monthly or quarterly letter. Many are genuinely insightful; some are trite; a few are unintentionally hilarious.

The investment and trading strategies that follow in the letter are sometimes consistent with the reference scenario painted in the opening paragraphs, sometimes not. And the underlying scenario can change dramatically from month to month. No matter; most financial professionals desperately want there to be an underlying explanation of why markets move the way they do, even ex post facto, even if the view changes 180 degrees in a couple of weeks. 

Cold-eyed global macro traders will also reject their own reference scenarios in a heartbeat if the markets go the wrong way. They’ve all memorized John Maynard Keynes’s pearl of wisdom: “The market can stay irrational longer than you can stay solvent.” Flexible gamblers at heart, global macro traders keep several alternative reference models in their heads. They know that the big events that move markets can go in several directions and that the combinatorial possibilities of these events are many scenarios, some of which will earn them big bonuses and some of which will cost them their shirts.

“The key feature of successful hedge fund traders is that they are emotionally unattached to their views,” says Gerard Gardner, a strategist at UBS in New York. They are, however, very attached to winning.

Although the number of possible scenarios is theoretically endlessly large, in practice global macro traders (like all good strategists) tend to focus on a small number of really important events so they can create a manageable number of reference scenarios — whose respective impact on traded markets and the traders’ own portfolios they can very quickly calculate.

My goal in this article is not to predict the odds of different reference models unfolding over the next 12 months. Instead, I’d like to describe how a couple of plausible current reference scenarios are built, look closely at the political risk component of these scenarios and see if these political risks are becoming increasingly correlated over time, as indeed many financial markets are.

WITH FOUR BIG EVENTS, THERE ARE 16 POSSIBLE outcomes (two to the fourth power) in the reference scenario “decision tree.” Decision trees are powerful analytic devices that traders and strategists use to simplify complex outcomes into reference scenarios. At the CIA, I used such a tree to calculate the odds of a North Korean missile launch, and every one of the cases I teach in my Princeton University course, “Radical Innovation in Global Markets,” has a decision tree embedded in it.

Of course, in the real world not all events branch into just two outcomes. There is almost always a range, a distribution of possible outcomes between, say, Chinese GDP growth of 5 percent and 7.5 percent. On careful analysis, not all outcomes are equally likely, if the variables are correlated or causally related to one another.

In the real world the shape of the branch matters too. They are rarely straight. When a portfolio manager puts on a trade that an asset will move from price X to price Y over time T, he or she must also factor in Z variation in price between those two points. Risk management rules require the manager to have a hedge somewhere along the way that will blow him or her out of the trade if the price swings beyond Z. Traders refer to these blowout points as “stops.” As one macro trader says ruefully, “You can pick the right branch and still have it sawed off from under you.”

The Federal Reserve’s monetary stance is the first big event under traders’ scrutiny, as the FOMC’s decisions will drive asset markets around the world, for good or for ill. As one of our Ditchley strategists quipped: “Every central bank in the world is tied more or less to the Fed’s bloated balance sheet. The ones with a currency peg are completely tied.”

One branch leading from this event is moderate economic recovery, reflation of price levels, sustained U.S. government deficits, a slightly tighter Fed stance (and no more quantitative easing), gradual improvement in job creation, gradual repair of household and bank balance sheets, and a sideways movement of the trade deficit.

In this branch, continued dis-saving by Washington is matched by household savings and the purchase of  Treasury debt by foreigners and Bernanke’s Fed, and this is what powers GDP recovery — at least for a while. The QE2 numbers are staggering: According to UBS, “the $850 billion in total Fed purchases offsets Treasury net financing requirements of $732 billion during the November-June period by about $118 billion.” In plain English, one part of the government (the Fed) was funding all the other parts (through the Treasury), so taxpayers were collectively getting more back from Washington than they were paying in. That’s almost better than the Fed dropping bundles of $100 bills from helicopters.

The other branch of this part of the decision tree says this party can’t go on for much longer and leads to slower economic recovery, flat employment and selective deflation (or the dreaded “stagflation”), some nominal reduction of the federal deficit, a continued expansive Fed stance and gradual shrinkage of the trade deficit. The first branch might be described as “business as usual,” the second as “malaise” or “painful adjustment.” At the end of the day, the latter scenario writes off QE2 as a dangerous illusion.

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