The sky is clearing and the night
Has cried enough
The sun, he come, the world
to soften up
Rejoice, rejoice, we have no choice but
To carry on
-Crosby, Stills, Nash and Young
Well maybe rejoice is not tops on investors’ minds, but one thing is certain: they sure have had enough of the carry trade. The carry trade was simple: borrow money from a country with low interest rates and reinvest the proceeds to one which provides a higher yield. Seems simple enough, so hedge funds and trading desks around the world put the trade on—specifically, they borrowed from the Japanese, who kept interest rates close to zero for some time, and invested the money into emerging markets where returns were dizzying.
And so we enter the next phase of the financial crisis: the moment when the music stops playing and everyone scrambles for an empty chair. In this case, managers were busy unwinding the carry trade at an aggressive pace. As the process started, it then triggered margin calls on traders, amplifying the pressures on them to sell. Add to this fact the underlying flight to quality amid market turmoil and you can see how a massive trade that had taken years to build up (some say there was $500 billion tied up in the carry trade), could unwind in a matter of months.
As a result, the Japanese yen has soared in value—up approximately 30% against the euro over the past month (a 6-year high). While these kinds of moves may have become the norm for stock and commodity markets, they can wreak havoc when they occur in currency markets, because it becomes nearly impossible to price exports or imports. Additionally, investors have to unwind both sides of the trade, which means that as they are re-purchasing yen, they need to sell those assets that were intended to deliver the outsized returns. In this case, the deleveraging and panic that has caused the Japanese, as well as many emerging markets, significant damage. Earlier this week, Japan’s Nikkei index was at its lowest since 1982 and the MSCI index of non-Japanese Asian stocks was down 33% in October. To stop the currency panic, there could be government intervention on the horizon.
The good news out of all of this is that ultimately, the currency revaluation process should lead to a more solid system. It is likely we will hear calls for intervention and oversight of currency trading, but for now, if you are getting gloomy, just hum a few of those lyrics noted above…Rejoice, rejoice, we have no choice but To carry on…”
Friday, October 31, 2008
Thursday, October 30, 2008
Deflation Formation
After more than a year into the rate cut cycle, the Federal Reserve announced that it was cutting short-term interest rates again yesterday. The US central bank pushed its benchmark federal funds rate down half a percentage point to 1% and signaled that more rate cuts are a possibility, noting that "downside risks to growth remain." Joining the Fed in the action was China, which cut rates for the third time in six weeks, amid a worsening growth outlook for its export-dependent economy and Norway, which cut its benchmark interest rate for the second time in two weeks. The European Central Bank and the Bank of England are expected to follow next week and Japanese authorities signaled they too might cut rates from ½ point to ¼ point.
Now that US rates are at levels not seen since 2002, fears are re-emerging that deflation will haunt the economy and keep us buried in a stagnant state for years to come. Simply stated, deflation occurs when consumer prices fall broadly. The problem with deflation is that it can lead to a vicious cycle: falling prices diminish corporate profits, which can lead corporations to reduce headcount. When consumers are worried about the job market, they are less likely to spend, which hurts profits once again. The most recent example of deflation was seen in Japan in the 1990’s. After that country’s real estate and stock market boom and bust, its economy ground to a halt. While the Japanese central bank lowered interest rates to zero and held the rate there, the economy still did not respond. In fact, only when officials there recapitalized banks, did the economy revive.
According to a number of analysts, the chances that the US will avoid deflation are pretty good. The primary reason is that the Fed is on the case much more aggressively than the central bank in Japan was. In addition to cutting short-term rates, the Fed has an arsenal ready to deploy in order to fight potential deflation. It can conduct operations to bring Treasury or private securities’ rates down, they can finance fiscal stimulus and they can undertake “quantitative easing” of monetary policy, which simply means that the central bank floods the system with liquidity. So while it is true that the Fed can only cut short term rates to zero, it is not constrained in how much it can increase its own balance sheet by making loans or acquiring assets. It can create new bank reserves at will and use those reserves to make loans itself or take on distressed assets.
Other reasons to believe that deflation may not be coming on the horizon include: while home and commodity prices are in fact falling, the current decline represents a reversal of the major spike that occurred leading up to this time; companies will quickly cut capacity to balance supply and demand; and some of the emerging global declines in goods prices are declines in relative prices, not prices generally. This is not to say that the credit crunch is not deflationary in nature or that prices are not coming down. Nor does this line of reasoning rule out the idea that deflation could envelop the US economy, but at this stage, it seems less likely to occur in the near term.
Now that US rates are at levels not seen since 2002, fears are re-emerging that deflation will haunt the economy and keep us buried in a stagnant state for years to come. Simply stated, deflation occurs when consumer prices fall broadly. The problem with deflation is that it can lead to a vicious cycle: falling prices diminish corporate profits, which can lead corporations to reduce headcount. When consumers are worried about the job market, they are less likely to spend, which hurts profits once again. The most recent example of deflation was seen in Japan in the 1990’s. After that country’s real estate and stock market boom and bust, its economy ground to a halt. While the Japanese central bank lowered interest rates to zero and held the rate there, the economy still did not respond. In fact, only when officials there recapitalized banks, did the economy revive.
According to a number of analysts, the chances that the US will avoid deflation are pretty good. The primary reason is that the Fed is on the case much more aggressively than the central bank in Japan was. In addition to cutting short-term rates, the Fed has an arsenal ready to deploy in order to fight potential deflation. It can conduct operations to bring Treasury or private securities’ rates down, they can finance fiscal stimulus and they can undertake “quantitative easing” of monetary policy, which simply means that the central bank floods the system with liquidity. So while it is true that the Fed can only cut short term rates to zero, it is not constrained in how much it can increase its own balance sheet by making loans or acquiring assets. It can create new bank reserves at will and use those reserves to make loans itself or take on distressed assets.
Other reasons to believe that deflation may not be coming on the horizon include: while home and commodity prices are in fact falling, the current decline represents a reversal of the major spike that occurred leading up to this time; companies will quickly cut capacity to balance supply and demand; and some of the emerging global declines in goods prices are declines in relative prices, not prices generally. This is not to say that the credit crunch is not deflationary in nature or that prices are not coming down. Nor does this line of reasoning rule out the idea that deflation could envelop the US economy, but at this stage, it seems less likely to occur in the near term.
Wednesday, October 29, 2008
Confidence, the Julie Andrews Way
I have confidence in sunshine
I have confidence in rain
I have confidence that spring will come again
Besides which you see I have confidence in me
-Rodgers & Hammerstein in “The Sound of Music”
I know that I have used this lyric previously, but any chance to hum along to “The Sound of Music” is fine with me, especially amid the tumultuous economic times in which we live. With that said, there is a connection between Broadway and Wall Street, which parenthetically, do actually physically intersect in lower Manhattan.
Yesterday, the Conference Board, a not-for-profit organization that provides and disseminates research, released its monthly survey of consumer confidence. Like many of its peers, this index attempts to gauge consumer attitudes on present economic conditions and expectations of future conditions. In other words, they want to know how we feel. The answer as of October 21 from the 5,000 people surveyed is that they feel glum. The Conference Board reported that last month’s index fell to a historic low level of 38.0, down from 61.4 in September and far worse than the average forecast of 51.5 (the index is measured against a bogey of 100, which was the 1985 level).
Why were market-watchers initially fretting about these results? The answer is that consumer spending accounts for more than two-thirds of the economy, so investors want to know what consumers are up to and how they might behave in the near future. The more confident consumers are about the economy and their own personal finances, the more likely they are to spend—and in the current state of the dismal economy, the opposite is also true. With this in mind, it's easy to see how this index of consumer attitudes gives insight to the direction of the economy and potentially, to the stock and bond markets. There is a caveat (isn’t there always?!). While the level of consumer confidence is associated with consumer spending, the two do not move in tandem each and every month -- sometimes people say one thing, and do another.
By the end of the day, investors had decided that the confidence measure was not as bad as thought. After all, don’t we already know that people feel rotten? In fact, the reasoning goes, the stock market is in the process of discounting all of that negative stuff, which is why stock prices have dropped off of a cliff in October. You could almost hear people convince themselves of this fact throughout the day as stock prices increased. The final hour was crazy as the buying reached a frenzied pace. When it was over, the Dow and S&P 500 had soared nearly 11%, while the NASDAQ surged by 9.5%.
In other words, as of yesterday, investors were clear that while they were confident in the Conference Board’s results, they were less sure that the horrible numbers indicated anything new and trade-able.
I have confidence in rain
I have confidence that spring will come again
Besides which you see I have confidence in me
-Rodgers & Hammerstein in “The Sound of Music”
I know that I have used this lyric previously, but any chance to hum along to “The Sound of Music” is fine with me, especially amid the tumultuous economic times in which we live. With that said, there is a connection between Broadway and Wall Street, which parenthetically, do actually physically intersect in lower Manhattan.
Yesterday, the Conference Board, a not-for-profit organization that provides and disseminates research, released its monthly survey of consumer confidence. Like many of its peers, this index attempts to gauge consumer attitudes on present economic conditions and expectations of future conditions. In other words, they want to know how we feel. The answer as of October 21 from the 5,000 people surveyed is that they feel glum. The Conference Board reported that last month’s index fell to a historic low level of 38.0, down from 61.4 in September and far worse than the average forecast of 51.5 (the index is measured against a bogey of 100, which was the 1985 level).
Why were market-watchers initially fretting about these results? The answer is that consumer spending accounts for more than two-thirds of the economy, so investors want to know what consumers are up to and how they might behave in the near future. The more confident consumers are about the economy and their own personal finances, the more likely they are to spend—and in the current state of the dismal economy, the opposite is also true. With this in mind, it's easy to see how this index of consumer attitudes gives insight to the direction of the economy and potentially, to the stock and bond markets. There is a caveat (isn’t there always?!). While the level of consumer confidence is associated with consumer spending, the two do not move in tandem each and every month -- sometimes people say one thing, and do another.
By the end of the day, investors had decided that the confidence measure was not as bad as thought. After all, don’t we already know that people feel rotten? In fact, the reasoning goes, the stock market is in the process of discounting all of that negative stuff, which is why stock prices have dropped off of a cliff in October. You could almost hear people convince themselves of this fact throughout the day as stock prices increased. The final hour was crazy as the buying reached a frenzied pace. When it was over, the Dow and S&P 500 had soared nearly 11%, while the NASDAQ surged by 9.5%.
In other words, as of yesterday, investors were clear that while they were confident in the Conference Board’s results, they were less sure that the horrible numbers indicated anything new and trade-able.
Monday, October 27, 2008
Tips for Surviving the Unstable Job Market
The housing market is in the tank, the stock market was soon to follow—what’s next, you ask? Look no further than the jobs market. Although the unemployment rate stands at 6.1% nationally, the figure is likely to increase. Some economists believe that the rate will increase to nearly 8% before this is all over, while others believe that we are headed much higher.
Currently, the state with the highest unemployment rate is none other than little Rhody—that is, Rhode Island, whose 8.8% rate puts it atop of a most dubious list. Meanwhile at the epicenter of the housing crisis, California, the rate is 7.7%. These numbers pale in comparison to the Great Depression, when unemployment reached a staggering 25%. Even as the decade of the thirties was ending, the rate was still close to 15%. Since then, the highest unemployment rate nationally was seen in November and December of 1982, when it reached 10.8%.
These are sobering facts and if you have a job, you are indeed fortunate. But everyone should take his or her job with a grain of salt right now and instead prepare for the worst. To that end, here are seven tips for surviving the unstable job market that the nation faces.
1. Stockpile cash: In normal economic times, financial planners recommend maintaining 3-6 months of your general living expenses. These are obviously not “normal” times and in fact, we are facing a nasty recession ahead, therefore, it is preferable to have 6-12 months of cash available in cash equivalents, like savings and checking accounts, short-term CDs or money market accounts.
2. Create Cash flow: Although it would be great to always know what you spend, it is even more important to create a detailed analysis of your expenses and to identify what can be cut or reduced. Considering that everyone feels out of control right now, the simple technique of identifying what is coming in and what is going out can help you come up with short, intermediate and long term game plans. The process is hard, but well worth the effort.
3. Explore a home equity line of credit or a re-finance while you still have a job. As you probably know, it is easier to qualify for a loan when you have an income. This is only possible if you have a high credit score.
4. Health Insurance: review your current benefits and explore your alternatives. It would also be advisable to understand the rules of COBRA (you can pay for 18 months of extended coverage) and you should use any deferred money that you have set aside.
5. Review your company policy on unused personal, sick and vacation days.
6. Prepare your resume, update your contact list and learn how to use the web for networking.
7. Print out any personal documents that may be on your work computer and take home personal papers from the office.
Currently, the state with the highest unemployment rate is none other than little Rhody—that is, Rhode Island, whose 8.8% rate puts it atop of a most dubious list. Meanwhile at the epicenter of the housing crisis, California, the rate is 7.7%. These numbers pale in comparison to the Great Depression, when unemployment reached a staggering 25%. Even as the decade of the thirties was ending, the rate was still close to 15%. Since then, the highest unemployment rate nationally was seen in November and December of 1982, when it reached 10.8%.
These are sobering facts and if you have a job, you are indeed fortunate. But everyone should take his or her job with a grain of salt right now and instead prepare for the worst. To that end, here are seven tips for surviving the unstable job market that the nation faces.
1. Stockpile cash: In normal economic times, financial planners recommend maintaining 3-6 months of your general living expenses. These are obviously not “normal” times and in fact, we are facing a nasty recession ahead, therefore, it is preferable to have 6-12 months of cash available in cash equivalents, like savings and checking accounts, short-term CDs or money market accounts.
2. Create Cash flow: Although it would be great to always know what you spend, it is even more important to create a detailed analysis of your expenses and to identify what can be cut or reduced. Considering that everyone feels out of control right now, the simple technique of identifying what is coming in and what is going out can help you come up with short, intermediate and long term game plans. The process is hard, but well worth the effort.
3. Explore a home equity line of credit or a re-finance while you still have a job. As you probably know, it is easier to qualify for a loan when you have an income. This is only possible if you have a high credit score.
4. Health Insurance: review your current benefits and explore your alternatives. It would also be advisable to understand the rules of COBRA (you can pay for 18 months of extended coverage) and you should use any deferred money that you have set aside.
5. Review your company policy on unused personal, sick and vacation days.
6. Prepare your resume, update your contact list and learn how to use the web for networking.
7. Print out any personal documents that may be on your work computer and take home personal papers from the office.
Trimming the Hedges
In July, 2007, I wrote an article about hedge funds. Way back then, when everyone and his brother was just dying to work for, start or invest in a hedge fund, I noted that
“Only the cream of the crop end up in the big leagues, while the rest of the heap slug it out in the minor leagues.” Well over a year later, it appears that there are problems in both the big leagues and the minors. Hedge funds are on track to have one of their worst years ever.
Louise Story noted in the New York Times (10/23/08) that “The gilded age of hedge funds is losing its luster.” Storied names in the industry have seen portfolios halved this year and smaller ones have been forced to close as once-aggressive investors run to the sidelines. I have heard a familiar story from many sophisticated investors: “My love affair with hedge funds is over!” No longer can hot-shot managers promise 1% per month with low risk, because it is simply impossible to deliver. One family friend noted “I could save the 2+20 (referring to the average hedge fund fee structure which amounts to 2% annual fee plus 20% of the profits) and lose the money myself or with a buy side manager for only 1%!” This guy had invested in six hedge funds as of last quarter, but now has just one.
Of course this type of thinking creates a vicious cycle: the massive number of investor redemptions puts more pressure on managers to unwind trades, forcing sales across every asset class, which in turn causes everything to drop in value and thus perpetuating more redemptions. And when people decide enough is enough, they throw the towel in on everything, even the stuff that is doing well.
As a case in point, my pal started a currency hedge fund at the beginning of the year and is actually in the plus column through yesterday’s close. Yet he is fearful that his major investor will not be interested in assuming any more risk when the redemption window opens early next year. While they have no complaint about performance, it is simply a decision to reduce risk. Of course my friend knew that this was a risk that existed when he started out, so there are no sour grapes, but it does beg the question, does the world really need over 10,000 hedge funds? Probably not, but it will be interesting to see which ones survive and how the pension and endowment world will view the world of “alternative investments” when they no longer are making easy money.
Like most booms and busts, there will be talk of the entire industry disappearing, but those predictions are usually overblown. Even the dot-com meltdown resulted in a few strong and profitable companies that thrive to this day. The more sobering question that smaller managers will ask is where can they go? With layoffs escalating on Wall Street, many of these guys may be left to make money by simply trading their own investment accounts -- at least until the process of hedge trimming is complete.
“Only the cream of the crop end up in the big leagues, while the rest of the heap slug it out in the minor leagues.” Well over a year later, it appears that there are problems in both the big leagues and the minors. Hedge funds are on track to have one of their worst years ever.
Louise Story noted in the New York Times (10/23/08) that “The gilded age of hedge funds is losing its luster.” Storied names in the industry have seen portfolios halved this year and smaller ones have been forced to close as once-aggressive investors run to the sidelines. I have heard a familiar story from many sophisticated investors: “My love affair with hedge funds is over!” No longer can hot-shot managers promise 1% per month with low risk, because it is simply impossible to deliver. One family friend noted “I could save the 2+20 (referring to the average hedge fund fee structure which amounts to 2% annual fee plus 20% of the profits) and lose the money myself or with a buy side manager for only 1%!” This guy had invested in six hedge funds as of last quarter, but now has just one.
Of course this type of thinking creates a vicious cycle: the massive number of investor redemptions puts more pressure on managers to unwind trades, forcing sales across every asset class, which in turn causes everything to drop in value and thus perpetuating more redemptions. And when people decide enough is enough, they throw the towel in on everything, even the stuff that is doing well.
As a case in point, my pal started a currency hedge fund at the beginning of the year and is actually in the plus column through yesterday’s close. Yet he is fearful that his major investor will not be interested in assuming any more risk when the redemption window opens early next year. While they have no complaint about performance, it is simply a decision to reduce risk. Of course my friend knew that this was a risk that existed when he started out, so there are no sour grapes, but it does beg the question, does the world really need over 10,000 hedge funds? Probably not, but it will be interesting to see which ones survive and how the pension and endowment world will view the world of “alternative investments” when they no longer are making easy money.
Like most booms and busts, there will be talk of the entire industry disappearing, but those predictions are usually overblown. Even the dot-com meltdown resulted in a few strong and profitable companies that thrive to this day. The more sobering question that smaller managers will ask is where can they go? With layoffs escalating on Wall Street, many of these guys may be left to make money by simply trading their own investment accounts -- at least until the process of hedge trimming is complete.
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