March 2, 2005
What Is And What Should Never Be
The counterintuitive reaction in the markets to Fed tightening is why curve bears are prophesizing that the unwinding of ‘the carry’ will not go smoothly. By ‘not go smoothly’ this is not to say that a flattening curve will not only spark earnings woes in financial stocks – a moderate decline in earnings does not necessarily mean the unwind is proceeding chaotically - but that some leveraged market participant(s) will collapse and/or trigger a chaotic unwind of theirs and other carry trades. The danger under such a scenario is that long-term U.S. interest rates will not simply rise, but spike uncontrollably higher.
Mr. Gross and others have been selling the ‘collapse’ outlook for some time, and the odds of such a scenario – according to curve bears – only continued to increase.
“And for those institutional foreign bond holders, and the "hedgies" domiciled in the Caymans, there’s no doubt too that a higher and higher short rate reduces and in some cases eliminates "carry," leading to collapsed positions and ultimately higher yields further out on the curve.” Gross
Incidentally, whether or not some ‘leveraged participants’ (i.e. hedge funds) are near the brink is a matter of curve speculation. To be sure, Greenspan has long been against regulating hedge funds (and the OTC market for that matter), and – even as hedge funds expand to service a wider clientele – he has maintained his stance that hedge fund are secluded investment vehicles for institutional types only. As such, thanks largely to Greenspan a thorough investigation of hedge funds is impossible at this time.
“Institutional investors have accounted for a growing share of hedge fund investments, and they can and should protect their own interests rather than rely on the limited regulatory protections…” Greenspan. Aug 2004.
How Mr. Greenspan kept a straight face while belting out ‘their own interests’ is unknown. Regardless, in light of previous statements what is clear is that Alan offers as much intellectual contradiction when it comes to the hedge fund regulation issue as he is does with gold.
“Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own.” Greenspan. Oct 1998
Suffice to say, with liquidity aplenty ‘the seizing up of markets’ seems like distant nightmare not likely to come to pass anytime soon…and yet the Fed keeps tightening.
Good Times Bad Times
Those that have been successful in plotting the bond market’s path in the past – Bill Gross included – are currently confronted by logic defying developments that “are as rare as Ahi tuna that never hits the grill.” With this in mind, and contrary to the conclusions of Contrary Investor, the reality isn’t that ‘markets will reflect economic reality’, but that the financial markets are prone to bouts of excessive optimism and pessimism that push the envelope of what is historical precedent.
The value investor has profited in recent years from owning gold to hedge against a dollar decline, by purchasing equities when traditional valuation measures are attractive and business prospects are understood, and by holding cash. With the exception of cash – which has (depending on which cash) underperformed during the U.S. stock market bounce - the value investor is still well served by deploying the same type of strategy today. In fact, the only BIG question the value investor needs to ask is whether or not an end to the carry will send gold (which is a future inflation indicator) into a death spin.
What determines success for the value investor is whether or not they remain stubborn enough to remember that the immediate path of any financial market is largely unpredictable; that while history often rhymes a bet on an exact repeat is simply that.
Clichés aside, the plight of the curve bears is a reminder that seemingly logical investment choices are not always the correct and profitable choice in the short term. Accordingly, instead of trying to play the curve, the value orientated long-term investor should only acquire positions that stand to profit in both good and bad economic and financial market times.
Babe I’m Gonna Leave You
Obviously the above value investing notes are the required caveat before drawing out some final speculations on the of carry disintegration theme. To reiterate the sentiment of the caveat, unless the investor remains grounded they run the risk of turning their risky macro speculations into win/lose investment choices.
With that warning out of the way, the CRB index hit a 24-year high this week, the U.S. housing market is showing signs of slowing down, according to CSFB risk appetite is in the euphoria zone, and the Fed is promising to raise interest rates. Making perfect sense out of all of these things is impossible, and is not really required. Rather, what is required is the basic knowledge that current trends in interest rates, commodity prices, rigged inflation reports, and asset prices (the housing example will suffice) can not continue indefinitely -- unless you believe in miracles something or someone related to the curve is inevitably in for a rude awakening.
Along with all of the fantastic financial market occurrences today, the trillion plus dollar hedge fund market is growing wildly, and - if history indeed rhymes - is likely to continue growing at a phenomenal rate until the next LTCM arrives. Quite frankly, it will take an increase in long-term U.S. interest rates or some type of type of financial crisis for investor intrigue in hedge funds to go down like a lead balloon. But make no mistake, when hedge fund excitement starts to wane the nightmare of market seizure could quickly come into view.
In summary, the U.S. Federal Reserve Board will continue raising interest rates until, as Puplava puts it, ‘something breaks in either the financial markets or the economy’. If, after this inevitable break, risk appetite craters like a Lead Zeppelin the nightmare that is market seizure will quickly arise, and those investors that attempted to defy logic will be exposed as the ‘complete idiots’ they are. Only after all of this will the curve bears switch their focus and begin attacking the soft landing voices as being overly optimistic.
The U.S. economic and stock market recovery was the best that money could buy, but signals from New York to Tokyo are now flashing a warning: money is going to continue getting tighter. With apologies to Led-Zeppelin, Dancing Days are not here to stay.
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