The panic selling that hit high-yield bonds, high-yield currencies, and emerging-country debt and equity markets last month has utterly destroyed market consensus.
Investors and traders now divide into two camps: those who feel the markets can effect an orderly unwinding of the global carry trade as the US Federal Reserve proceeds with a measured return to normal monetary policy, and those who see a bubble bursting around us.
This divergence of opinion is a very good thing. Whenever the whole herd of short-term traders and long-term investors comes to agree on one view of markets, they are almost certainly going to be proved wrong. And when they all suddenly surge to escape their ill-judged positions and find no-one to take the other side of their trades, prices gap down and the unfortunate get trampled to death.
We?ve already had a taste of this and a hint, too, of how carefully crafted diversification strategies can break down. In extreme markets, correlation vastly increases. It?s not just long-only players of the reflation trade that are suffering. HFRX hedge fund indices measure returns on eight classes of hedge funds: global macro, convertible arbitrage, relative value arbitrage, distressed securities, event driven, M&A arbitrage, equity hedged and equity market neutral. They all produced losses in April. By May 26 only one group ? equity market neutral ? was showing a gain for last month; the rest were in negative territory.
This is not how it is supposed to work.
Some hedge funds will collapse as a result of this turmoil. It only remains to be seen which ones and how big they will be.
James Montier, global equity strategist at Dresdner Kleinwort Wasserstein, is firmly in the bear camp. He contends that outstanding positions in the global carry trades and leverage remain enormous and that when these trades snap, devastation will follow. (Postcards from the edge IV ? Pouring oil on troubled waters and the slow death of equities, May 19). He points to open interest (longs plus shorts) in five-year and 10-year US government bond futures as a measure of leverage in the bond markets. By the middle of May this stood at 2.6 million open contracts, five times greater than the 0.5 million contracts that were open in 1994, implying the highest leverage ever seen.
Inspired by analysts at
www.contraryinvestor.com, Montier has been calculating borrowings of the 24 primary dealers in US government bonds. These include the leading investment banks, which have been delighting equity investors with huge profits built on steadily increasing value at risk (VaR) numbers. Their borrowings stood at over $700 billion in mid May, compared with well under $200 billion in 1994.
Bank traders themselves argue that they have learnt from past market convulsions to improve their liquidity management: to build in a cushion so that they do not have to sell good assets to cover losses and calls on worsening positions in illiquid markets. They proved themselves when rates rose last summer.
The bulls? line is that the recent sell-off has knocked the froth off over-excited markets and that investors can now move back in and buy value.
That doesn?t sound very convincing. The market is turning risk averse.
By mid May the market was pricing in a 110 basis point rise in US rates by the end of this year. Assuming that the market is bound to be wrong, the question becomes: how much bigger or smaller than this will the rise be?
The Fed says that it is no longer worried about deflation ? a prospect it always saw as unlikely to arrive but highly damaging if it did ? but neither does it see clear risk from inflation. And while the Fed does not target asset prices, is it likely that Alan Greenspan in his last two years in office will crater the markets with rapid rate rises?
Markets will either behave much more calmly in the weeks and months ahead than the bears are betting, or there will be a blood bath. The only thing that?s certain is that the easy reflation plays of 2003 and the first quarter of 2004 are now off. There?s no more easy money to be made.