Will the CME's new futures product, based on nonfarm payrolls data, allow investors to hedge against stock, bond, or currency market jitters?
You may already feel your own job prospects are a toss of the dice. Soon, though, you'll be able to bet on the state of the whole U.S. job market.
Starting in April, average investors can express their views about where the economy stands through a new futures product based on one of the most closely watched economic indicators: the nonfarm payrolls data contained in the Labor Dept.'s monthly employment report. It is the first of several financial derivatives based on economic indicators the Chicago Mercantile Exchange plans to launch.
The exchange says the payroll futures will let investors hedge against stock, bond, or currency market jitters amid worries about an economic downturn. Many traders and analysts, however, are skeptical the new product will be very popular beyond pure speculators.
The nonfarm payrolls number instantly joins such unsexy futures products as butter, soybeans, and random length lumber. Released by the Bureau of Labor Statistics (BLS) the first Friday of every month, the payroll number measures the total number of U.S. workers, except those in government, farms, some nonprofits, and working for themselves at home. As such, it is seen by economists as a timely, reliable indicator of the health of the broad U.S. economy. When released by the BLS, the monthly payrolls figure often moves the stock market, especially if it offers up a surprise.
Futures traders, of course, already bet on all sorts of predictable events: inches of snowfall, frost days, hurricanes. The concept of trading economic indicators is not new, either. Back in 2002, options based on the BLS jobs data were first traded in auctions hosted by Deutsche Bank (DB) and Goldman Sachs (GS). Today, a few economic and housing derivatives are traded on over-the-counter markets among banks and funds. But the price of those products can be skewed by things such as a participant's credit position and the limited number of possible buyers.
"What happens [with the OTC market] is that it's bilateral, and when credit dries up and you have less counterparties, the market becomes illiquid and less efficient," says Felix Carabello, director of alternative investment products at CME Group (CME), which is the newly merged Chicago Mercantile Exchange and Chicago Board of Trade. Some argue the opaque and concentrated nature of the over-the-counter market for many derivatives products is partly responsible for the plunging values of many housing-related securities held by banks.
But there are other challenges for an economics-oriented futures product. Most obviously, there is no tangible underlying asset for the contract, like there is for gold or corn. A company that uses the futures contract's underlying product—say, oil—could take delivery of the commodity, though it rarely happens. No one produces or consumes the nonfarm payroll number. Hence, there is no steady demand from businesses who must buy the futures in order to keep their operations running risk-free.
"The concept is kind of cool, but I think it will take a bit of time for the market to find its natural buyers," says Keith Styrcula, chairman of the New York-based industry organization Structured Products Assn. This lack of natural hedgers could leave only speculators to trade the economic-indicator futures.
The CME, however, believes it can find customers among those who trade in the U.S. dollar or other currencies, and in equities index-related products. For example, a currency trader who shorts other currencies—making bets that their values will decline—and goes long on dollars might expect the nonfarm-payroll number to go up from the previous month. Say a survey of economists, issued each month ahead of the BLS number, suggests the job number will in fact be lower—indicating the economy is slowing and the dollar may weaken. The currency trader could quit his long position in dollars and rebuild his currency position before the actual BLS number is released, or buy a put option on the to-be-released nonfarm-payroll number. Thus, his gain in the futures contract will offset his loss in currency trading, without incurring the transaction cost involved in exiting and reentering a currency position.
But it may be hard for little guys to gather the information needed to play that prediction game—and given the speculative nature of the market, it may be inadvisable for them to do so. "I don't think average investors would be able to participate," says a financial technician who works for a major investment bank's structured product department and is responsible for underwriting asset-backed securities. The complexity of financial engineering has reached the point where "even many of our clients who are mutual fund managers don't understand how exactly those highly complicated structured products work."
Some traders say the futures price will probably be a better predictor of payrolls than the consensus of economists is now. "When you have money on the line, you usually tell the truth," says Sam Hui, vice-president for Morgan Stanley's (MS) consolidated equities department. For example, last spring, economists at the National Assn. for Business Economics, a Washington-based nonprofit economic research organization, conducted a test in which economists were invited to "bet" on the May, 2007, nonfarm payroll number. The economists guessed there was a 30% probability the reported figure would exceed 150,000. In fact, it turned out to be 157,000.
"I'll probably try it," says Hui, referring to the new CME payroll product. But he doesn't expect many regular investors to join him at the table.