Are Hedge Funds a Good Deal?

Seeking Alpha has a nice post looking at hedge fund returns. If you are interested in the sector or curious about how to think about returns across asset classes I recommend it.

Rising Japanese Bond Yields

From Bloomberg:

Japan's 10-year government bonds fell as yields near a 14-month low deterred investors from buying amid signs the world's second-largest economy is growing.

A government report on May 30 will probably show Japan's industrial production gained in April, according to a Bloomberg News survey. The economy in the first quarter expanded at more than twice the rate forecast by economists.

Hard to see why this trend wouldn't continue. To change it I think you would need to see a hard landing in China.

Marc Faber on Currencies, Commodities

From the Bloomberg:

Once the US economy deteriorates, the Fed "will go back to the old medicine, which is essentially to print money and the dollar will weaken again," Faber said in an interview with Bloomberg News yesterday. "Compared with the euro, the Asian currencies are very, very inexpensive."
...
``The foreign exchange market will anticipate this easing beforehand'' resulting in a drop in the dollar, said Faber, adding that he was a ``reluctant'' holder of dollars.

Some investors and traders disagree. Fifty-nine percent of the 54 strategists, investors and traders surveyed globally on May 20 said the dollar is poised for its longest winning streak against the euro since 2000 on expectations the U.S. currency's three-year bear market has ended.
...
Faber is also betting on gold because it has become cheaper compared with commodities such as crude oil.

Today, one ounce of gold, trading at $417.60, is worth about eight barrels of oil, according to Faber. In 1998, when oil fell to less than $11 per barrel, gold was trading at about $285 an ounce. That's equal to about 26 barrels of oil per ounce of gold.

``You should be long gold and short oil,'' Faber said. Commodity markets ``aren't particularly attractive.''

Hard to disagree with any of that. I would not hold dollars right now - even "reluctantly".

The EUR/JPY chart I put up just before the strong U.S. retail sales numbers still seems very relevant.

Reading the Market Bounce

From the FT:

Are investors risk-seeking or becoming more risk-averse? The recent rally in equity markets suggests the former; the fall in Treasury bond yields and the widening of credit spreads suggests the latter.

I am not sure I would read too much into the equity bounce. Stocks got held underwater for several weeks before staging this rally. Markets never move in a straight line and it is really the new highs and lows that have meaning.

Certainly with the mixed economic data it doesn't hurt to keep an open mind but I am not sure a rally reflects risk-seeking so much as relief.

If Toll Brothers can make new highs I would take it as a sign that any bear bets have to wait.

South Korea Intervenes

Yes, they did say yesterday that they were done.

Details from the FT:

The Bank of Korea on Thursday backtracked on its comments that it did not plan to intervene further in the foreign exchange markets, after precipitating a sharp fall in the US dollar overnight.

Currency traders said it appeared that the central bank in fact bought dollar-denominated assets on Thursday morning, less than 24 hours after Park Seung, the governor, told the Financial Times that he did not "anticipate" doing so.

Baffled about how this would happen. It is not that difficult to give an interview and repeat stock phrases. Probably doesn't mean much over the short-run as traders will just be left ignoring all comments. In the long-run the loss of credibility could really limit the bank's options.

I've got to wonder if it is not some sort of bureaucratic foul-up, either on the intervention or the statement. Seems like somebody needs to lose a job over it.

* Update 10:20 - Brad Setser's thoughts:

What is going on? It sure seems like the Bank of Korea (the central bank) and the Ministry of Finance (if not the entire government) are in somewhat different places. The Finance Ministry is worried about any slowdown in growth, and Korea's export growth seems to be slowing. This policy dispute just played out in a very public way.

An Inflation Hawk

Capital Spectator sounds more hawkish than I am:

Nonetheless, the preference for seeing as inflation as yesterday's worry suddenly finds new popularity. It must be stated too that this optimism is built in no small degree on the house of energy and the expectation that the price rally in oil is now behind us.

Definitely good for a read. I am more of a slowing-growth-due-to-rising-risk-premiums dove but even if that proves correct oil prices can still cause inflation problems this fall or next year based on increased emerging market demand.

Tim Duy Weighs In

From Economist's View:

Why do I keep harping on the necessity for a significant slowing in growth before the Fed changes course? Just look at yesterday's comments by Fed Governor Donald Kohn, speaking to the Australian Business Economists: "... if growth is sustained and inflation remains contained, we are likely to raise rates further at a measured pace." And "The federal funds rate appears still to be below the level that we would expect to be consistent with the maintenance of stable inflation and full employment over the medium run." And, if that wasn't clear enough, "[W]e have not yet finished this task." These are remarkably candid remarks, and imply a high degree of confidence in the continuance of existing policy. The recent bearish feelings on Wall Street are clearly not receiving much validation in the inner circles of the Fed.

In reading these thoughts, I can't help but think about the FOMC's policy shift in January of 2001. Following the flow of statements from Dec 19th, to January 3rd, to January 31st the commitee shifts from "everything is fine, there is nothing to see here" (my flippant summary) to a call "for a rapid and forceful response of monetary policy" (their words this time). I bring this up to show how quickly the Fed is willing to change its mind when the data hits them with a 2x4.

At this point signalling an end to the hikes could relaunch the commodity rally (dollar fall) and bring about inflation but if we arrive at the June meeting with oil in the low 40's it seems to me the risks are tipping towards slower growth. The Fed doesn't know any better than anyone else if April's market moves are just volatility or a trend change so they lean towards maintaining the status quo. No harm no foul if they get it wrong in the statements leading up to the next meeting. Kohn can just change his mind.

Oil in the low 40's and credit spreads wider than today's levels, which seems very likely, and I expect the Fed will be done in June. A lot can happen in a month and a half though.

South Korea Says "No Mas!"

From the FT:

South Korea's central bank will not intervene any further in foreign exchange markets, the governor of the Bank of Korea said on Wednesday in comments likely to unsettle financial markets.

"I believe that we now have sufficient reserves to secure our sovereign credibility, so I do not anticipate increasing the amount of foreign reserves further," Park Seung told the Financial Times. South Korea's foreign currency reserves stand at $206bn the fourth largest in the world.

Mr Park said: "We now need to take more consideration of profitability, and I think we're at a stage where we need to manage our reserves in a more useful way."

This will be harder to shrug off than Norway's sales.

Greenspan Staying?

Calculated risk picks up the news that Greenspan may stay a few months longer than expected. Not sure I see the logic in that but I guess I should be used to that.

Equities, Bonds, and Inflation

I imagine we are making near term highs in the equity markets. Maybe slightly above here over the next 4 days and then a pullback. Maybe to 36.20 in the QQQQ. I am chucking out some of my longs with plans to kick the rest out tomorrow. Maybe we are into a topping process that leads to some good long term shorts but I would say it takes a couple of weeks and will be staying flat on equities and watching.

I am going to start building a long bond short in here. Going to go slow as it seems like the dollar might need to top out to create any real weakness.

I don't see this mornings inflation number as a problem and generally just see it lagging the PPI top. I don't see how that top can get taken out without a massive reversal in commodities. Those charts are disaster zones and probably need to base for 2 months. If I am wrong and that rally relaunches I would reconsider my view that inflation fears peaked in March and are headed lower.

Auto Supplier Bankruptcy

My brother works as an engineer at an autoparts supplier and he asked me if he should buy some shares in Collins & Aikman, which filed for chapter 11, yesterday while it trades around $0.10. I replied that he has plenty of risk on the books just by working in the industry and that the action will be in bonds once the stock price is below a buck.

The company has some 2011 bonds that are trading near $0.40 at a roughly 35% yield. It may have overshot in the short-run but at those levels there is not much hope for the stock. I mentioned investinginbonds.com as a source for corporate bond prices the other week and while it is not a very good market for individual investors the prices can give some insight into a company's prospects. Definitely worth checking out before playing in the equity.

Norway Sells Half its U.S. Treasury Bonds

From Reuters:

A surprisingly small flow of foreign money to the United States in March was due mainly to a halving of oil-rich Norway's U.S. Treasury bond holdings, raising questions about whether overseas governments are cutting huge holdings of U.S. assets.

A U.S. Treasury report on Monday showed the net flow of foreign investment to U.S. securities at $45.7 billion in March -- more than $20 billion below expectations and less than needed to cover the $55 billion U.S. trade deficit that month.

Foreign official institutions, consisting mainly of foreign central banks, were net sellers to the tune of $14.98 billion.

Close examination of the data shows these sales were dominated by Norway's more than halving its holdings of Treasury bonds to $16.9 billion from $33.8 billion.

Analysts said Norway's holdings are most likely those of the $160 billion Government Petroleum Fund, a fund of foreign stocks and bonds set up in 1996 aimed at saving oil and gas revenues for the future, when energy resources run out.
...
Norway's Treasuries holdings rose by more than $20 billion in the second half of 2004 to $35.1 billion in January, said Goldman Sachs economist Thomas Stolper. He added that March looked consistent with a very active investment stance.

This was an interesting take on some pretty widely covered news. As Brad Setser says, "...Norway is not likely to sell $17 billion of Treasuries every month." Even so I am surprised the euro didn't get a little more mojo back against the dollar.

Today's news continues the trend of taking some pretty surpising data in stride. In the last two weeks we have gotten over strong employment data (too construction heavy), a shrinking trade deficit (it was Chinese New Year), and strong retail sales (screwed up by Easter). My answer to all this is that the market is just not focused on the data. It probably doesn't help that there has been a pretty mixed picture.

I kind of feel the path of least resistance for the markets is higher (lower for UST bonds) as lots of people seem to be looking at long-term problems to drive current prices. This is most noticable in housing but so far there is little sign that market can't stay strong through the fall.

Hedge Funds vs. Day Traders

From The Guardian:

The herding instincts of investors are truly remarkable. Similar beasts stick together, chasing the same stocks at the same time and often risking great financial peril, but such instincts can also overwhelm very different investor species. In recent times the grandest of hedge fund managers have found themselves thundering shoulder to shoulder with the scruffiest day traders ... towards oblivion.

The article makes some interesting comparisons but its probably a little over the top. Entertaining reading though.

Volatily Spiking Again

The scariest part of today's action has to be the spike in the VIX back near 18. The VIX bounced its way down to the 12 level over the course of 2 years and this quick move up is going to cause a lot of pain for options sellers. Besides that the higher vol will require options hedgers to sell increasingly larger size into the market as it heads lower. Implied and actual vols are also used pretty heavily to measure the risk on trading books so this move really has the potential to pull liquidity from the market.

As I mentioned all the talk of hedge fund trouble this week I was a bit skeptical. A rising VIX makes me a lot less skeptical.

Confusion

The data and market reactions over the last couple of days have left me pretty confused. I am focused on the commodity weakness. In March the reason for Fed tightening was the inflation coming through the system and made obvious by the highs being hit in the CRB, oil, copper, steel and too a lesser extent houses. Now the commodity sector has backed off considerably. This could be viewed as evidence that growth is slowing in Asia. It should reduce the need for Fed tightening.

Ditto for the widening of corporate spreads. It was a sign of excess liquidity but now the rising risk premiums have taken that argument off of the table.

The dollar strength evident yesterday should also give the Fed more options.

Throw in a couple of good data points on the economy and the thought that securities markets could be distorted in here by hedge fund troubles and I am having a tough time knowing what to think.

Evaluating USD Strength

While the dollar is showing some strength on the smaller than expected trade deficit, I am not convinced it means a whole lot. I still tend to view Asia vs. Europe as the better risk trade but the U.S. is not fixing any of its longer term problems, so it will probably resume its downtrend eventually. The new budget (mentioned here via Brad Setser and here via Mark Thoma) is just adding to capital account needs and over time the trade numbers will reflect these policy mistakes.

Bill Cara explores the dollar's overnight strength and concludes with this:

I say that if the Bank of China does not revalue the Renminbi yuan this weekend, which is a longshot at best, there will be serious hedge fund failures next week. That's because traders like me are massively short the dollar and will have to close those positions.

Financial Armageddon just could be at hand, and we all were looking at the GM equity-bond trade issues as the biggest problem for some hedge funds when we should have been looking at the Dollar.

Traders cover losing bets all the time but hedge fund failures are a bit more infrequent. It is certainly in the air this week but with JPY below 136 to the EUR I am not sure people are that stressed. Below is a EUR/JPY chart with 4 hour bars.

Click on the chart to see a larger image!!
Posted by Hello

That seems like where the renminbi revaluation expectations have been most pronounced and probably where their is the most risk of a snapback. Greenspan's speech swung some weight behind the idea that China was facing internal pressures to revalue and that is a very persuasive argument for macro funds. The U.S. trade deficit doesn't seem like much of a catalyst in the trade. More of a distraction.

Explaining the Hedge Fund Rumors

From the FT ($$):

According to Mike Harris, credit derivative strategist at JP Morgan, hedge funds had been putting on a trade which involved buying the equity tranches (the most risky) and going short (gambling on a decline) in less risky mezzanine tranches. They leveraged up this trade by selling protection (options) against the equity portion. That trade gave investors a positive carry since the yields on the riskiest tranche were higher than the yields on lower tranches.

But the emergence of idiosyncratic risk in the form of the downgrades at General Motors and Ford has caused the spread on the equity tranches to widen, causing losses for the hedge funds putting on this trade. As they attempted to unwind their positions, the selling pressure pushed prices down even further.

There is a saying (mostly in currency markets) that goes "the road to hell is paved with positive carry." That people would have this kind of trade on and lose money doesn't really surprise me. That anyone would have it on in big enough size to risk their solvency would.

When considering trades like this it never hurts to just look at being naked long the riskiest portion in much smaller size (targeting an equal return). Usually when the trade goes bad the variance in the bid/offer spread has been grossly underestimated. Its possible that an unhedeged position might get the same yield with about 1/20th the notional value so if things go bad it's easier to dump it rather than hang on waiting for the bid/ask to tighten back to normal.

I have never traded the CDO market and am just assuming that like most derivatives the bid/offer is several times wider than on the underlying. When the underlying is a corporate bond that is a lot of hay just to break even on a spread trade.

Savings Glut or Investment Dearth?

I have been waiting patiently for Billmon at Whiskey Bar to post his 3rd entry on this issue. His first 2 pieces (Part I and Part II) were excellent and I highly recommend them to anyone who did not run across them already.

You'll probably want to read Nouriel Roubini's latest piece first as it is referred to at several points. It also provides context for the savings debate within a bigger economic picture.

Here is a taste of what Billmon says:

Instead, the problem appears to be a variation on the same theme Keynes explored 70 years ago: Private individuals with savings to lend are holding out for a higher price (interest rate) than borrowers are willing to pay - and in America's case, probably higher than it could afford to pay, given the quantity demanded.

By afford, I don't mean America is literally too poor to cover the vig, but rather that the interest rate required to finance the current account deficit solely from private sources would slow the U.S. economy and short circuit the current investment recovery - thus drastically reducing, if not eliminating, the demand for foreign savings.

This state of affairs has forced the ODIC governments to step into the breach and provide the financing that private lenders are no longer willing to offer. In effect, they are forcing the savings-investment market to clear - at an artificially low price. We can assume they are not doing this out of the goodness of their hearts or because of the kindness of strangers. They are propping up the market because they, too, are afraid of the deflationary wolf and so far haven't figured out another way to generate the kind of growth rates they need to stay one step ahead of it.

What makes all this such an interesting variation on the old Keynesian theme is that the recalcitrant lenders and the increasingly strapped borrowers happen to live in different countries with different currencies and different central banks - as well as different cultures, ideologies and geopolitical objectives, some of which may not be reconcilable.

I will probably be back when the series raps up with some thoughts. Until then I am keeping an open mind. This issue is extremely important though and perhaps even urgent. It seems like the next 6 months will see a short-term test of the "savings glut" thesis (a liquidity crisis). How that test works out just depends on where the long-term equilibrium actually is.

Hedge Fund Follow-up

These two articles show opposite side of yesterday's fears.

First from Bloomberg:

``It's more rumors than fact,'' said Brett Barth, a partner at BBR Partners LLC in New York, which invests in hedge funds for its clients. ``There are a handful of trades not working, so people are worried that there are hedge funds being forced to liquidate their holdings to meet redemptions.''

Next the NYT:

Another large hedge fund manager, GLG Partners, which is based in London and is 20 percent owned by Lehman Brothers, had losses ranging from 2.5 percent to more than 8 percent as of last month on some of the portfolios it manages, according to a person briefed on the results. Officials at GLG did not return e-mail messages sent to their offices yesterday afternoon. A spokeswoman for Lehman declined to comment.

Yesterday's sell-off began on European markets amid a rumor that Deutsche Bank stood to suffer losses because of its exposure to a hedge fund that was caught wrong-footed by the recent cut in the credit rating of G.M.'s debt. Shares of Deutsche Bank fell 3 percent.

I still have a hard time seeing the correlations between assets as high enough to prevent new money from flowing into disrupted areas. Not doing anything on the news but watching.

Yuan Revaluation Effects

Ezra Marbach summarizes a NYT article that lays out some possible effects of a renminbi revaluation.

GM Aftershocks

From the FT($$):

Many funds are believed to have bought GM bonds, which had fallen sharply in March following a profits warning, in the belief that the debt was oversold. Simultaneously, bets were placed short-selling the company's shares.

But last Wednesday, the stock leapt 18 per cent on news of billionaire Kirk Kerkorian's tender offer for shares in the struggling carmaker. On Thursday, Standard & Poor's caught the market off guard by finally downgrading the company to junk, pushing GM bonds sharply lower.

I did not think about this effect but it could be very powerful in the short-term. The risk is similar to the liquidity risk when LTCM went under. In the long-run either your bonds will pay off or the stock goes to zero but margin calls and marking-to-market are very real risks to levered players. Making it to see the long-term is the challenge.

It would need some pretty big knock-on effects into other issues to cause a real problem. Otherwise other funds who were uninvolved would be jumping into the bond stock spread or at least shorting GM stock against the $31 level.

Even easier for F with no looming bid.

*Update 4:00 PM - I having been looking at Merrill Lynch (MER) the last couple of nights and thinking it looked an aweful lot stronger than some other big financials (like Citigroup (C)). Since MER is involved in the GM bid I had kind of an "aha" moment thinking they would be prepositioned to pick up the pieces on a move like today. MER , however, is not holding up so well today so I guess I will just file my thought away for later.

Healthy 3-year Auction

From Reuters:

Treasury debt prices kept a grip on early gains on Tuesday as an auction of new U.S. government debt drew respectable demand, which may bode well for the rest of the week's $51 billion refunding.

The sale of $22 billion in three-year Treasury notes went at a high yield of 3.821 percent. It drew bids for 2.38 times the amount on offer, well above the 2.00 average of previous sales and the highest since the three-year was relaunched in May, 2003.

Indirect bidders, including customers of primary dealers and foreign central banks, picked up $8.66 billion, or 39 percent, of the issue. That was down slightly from February's 44 percent share, but in line with the average of 38 percent and a relief to traders worried that foreign demand could fall sharply. Primary dealers took $12.67 billion of the sale.

Still more auctions to come but this should be reassuring after last week's bond turbulence. I am a bit surprised the market has gotten over the strong jobs report so quickly. More strong data could cause a lot of pain.

Oil Futures Trade Contango

From the FT:

The crude oil futures market has produced plenty of hot news in the past 18 months. However, one of the more recent - and striking - developments has been the widening gap between nearby prices and the longer-dated prices, which has encouraged US refiners to buy oil and store it in the hope of selling it for a higher price later in the year.

This price pattern, known as "contango" - the industry term for when future delivery prices are higher than more immediate transactions - has reversed the normal price behaviour of crude futures markets. Usually nearby prices trade higher than longer-dated deliverable prices because oil markets have seen tight balance between supply and demand, which in turn pushes up nearby prices.
...
"Investors will have to hope that oil prices will have to rise strongly in absolute terms for them to hold on to their investments, because if the price were to remain flat and the steep contango persists, the losses will continue and their overall returns from crude futures will reduce," said Mr Lewis.

A while back I mentioned the spot market's focus on projected future shortages rather than current inventory levels. The market has now worked that out.

Tea Leaves

Looking through the charts today. The strength in housing looks impressive. Toll Brothers (TOL) is one of few charts that is still in position to challenge the March highs. It is especially impressive given that the bonds turned lower on the jobs report. I guess the market likes the construction jobs in spite of the higher rates. Same story in Fluor (FLR).

I also see strength in the Asian ETFs (EWY, EWS), semiconductors (INTC, SMH) and some of the retailers (SMRT, ANN).

Oil stocks look alright but other commodities sectors are still struggling near lows.

I am taking a wait an see approach to the charts. I would expect this rally to lead to some nice shorts in a bit but if home builders can break new highs it might postpone the markets demise by months.

Financial Risk Models

From the Mises Institute blog:

Although the mechanical philosophy is long dead and buried, our age is not without its own dogma regarding properly scientific explanations. Today, the prevailing belief is that any real science must be composed of mathematical models, models which yield quantitative predictions about some class of events based on particular, initial conditions, also specified numerically. Once again, the currently popular methodology has been imposed on diverse disciplines with little regard to whether it is suitable to their subject matter, but simply because it is thought to be the only respectable way to do science. The philosopher John Dupré calls this "scientific imperialism," meaning "the tendency for a successful scientific idea to be applied far beyond its original home, and generally with decreasing success the more its application is expanded" (2001, p. 16). Once again, we see a frantic effort to generate models fitting the accepted paradigm, with little regard for the realism of the assumptions and mechanisms from which they are constructed.

In my mind this relates prettly closely to this post from Brad Setser (be sure to read the comments which wade deeper into modelling and risk measurement). The basic problems in risk management seems to me that assets are assumed to have inherent properties like the physical bodies. Particles have mass, position and velocity while assets have price, varience, and correlation. I call it a basic problem because these aren't really the properties of the asset but are the properies of transactions.

Transactions necessarily have assets, counterparties, prices and times associated with them but assets need not be part of a transaction. A series of transactions in two identical assets need not have a realtionship at all if the counterparties have no contact. The existence of exchanges and the requirments of open-outcry and disclosure get around this basic problem, creating attachment between transactions but I am not sure this does much more than create the illusion that assets always have prices and those prices move in continuous fashion.

China's dilemma

This article provides some good food for thought about the timing of a yuan revaluation and the state of the Chinese economy. Some of the highlights.

Walker sees China hitting a wall, chiefly in the form of a labour shortage; not the much-publicised reluctance of inland Chinese recently to serve as factory fodder in the sweatshops of Guangdong, the industrial province bordering Hong Kong, but supply gaps in skilled workers and managers.
With about 1 million Taiwanese already employed on the mainland - about 10 per cent of the island's workforce and therefore probably close to the limit - newspapers in Hong Kong and South-East Asia are packed with ads for supervisory or technical jobs in China.

...

Nor was the diet of low-yield government paper doing much for profitability in the scandal-prone Chinese banks, whose non-performing loans Roubini and Setser put at somewhere between 46 and 56 per cent of China's GDP.
Also last week, the ratings agency Standard & Poor's said recapitalisation of two of the big four state banks - the Industrial and Commercial Bank of China, and the Agricultural Bank of China - would require injections of between $US110 billion and $US190 billion.

Indeed, the weak position of the Chinese banks and their huge requirements for capital are cited by Xie as one more reason against early revaluation. As well as adding to bad debts by raising domestic real estate and other prices in relative terms, a higher yuan would require more US dollar investment to achieve sound capital adequacy.
Although disposal of bad debts via asset management corporations is lagging badly, Chinese financial authorities are still hoping to bring two large banks - the China Construction Bank, whose assets are mainly infrastructure loans to governments, and the Bank of Communications, which already has a 19.9 per cent "strategic" holding by HSBC - to international share offerings in coming months.

A good general rule in economics is that flexibility and transparency lead to stability. Along those line I guess I can see why China's policies have left it with few good options.

Handy Bond Market Data

Brad Setser stuck in a comment that had me checking out bond data. I still have not found net long-term corporate issuance for 2004 but thought I would organize some of the resources I ran into.

Bond Market Association has a table of outstanding debt by sector from 1985-2004. Other BMA tables here.

Thomson Financial's capital market summary 4Q 2004 (U.S. total debt issuance by sector on page 13 shows long term issuance excluding MBS, ABS, and Munis down 2.5% from '03) and lots of other reports (mostly league tables) here .

The BMA also provides InvestingInBonds.com which is a good starting point for current bond prices and spreads. The corporate page will pop up the most active corporate issues and you can even watch a bond market ticker.

The U.S. treasure curve with swaps included is available at GovPx and there is a bond market outlook and news summary provided by Stone and McCarthy. You can also get economic headlines refreshed every 2 minutes if that is your pleasure.

NPR on Global FX Currency Traders

Five minute audio clip with the more interesting/entertaining stuff coming in the last 90 seconds. Quite a business model.

Summing Up the Week

We end the week weighing the auto downgrades and steepening yield curve (new 30-yr) against an unexpectedly positive jobs report and Kerkorian's bold bottom fishing maneuver in General Motors (GM).

On the auto downgrades it seems very likely that the bond market had already anticipated the downgrade. Its arrival shifts the focus off of the auto bonds and towards the wider bond market. I would not be surprised if GM and F bonds bottom here or shortly while junk spreads continue to widen. A best case would be junk widening while investment grade tightens but I would guess such a trend would be short lived. I am not really sure where Kerkorian's bid fits into this picture other than to muddy the waters. It is not clear what his motivations are and I am not sure that GM's equity is the best risk / reward trade in here.

I said any investment grade tightening might be short lived because the jobs report and new 30-yr created a lot of uncertainty in the long end of the yield curve. On Tuesday I thought the market would start to anticipate an end to the hiking cycle but this jobs report brings us back to considering 50 bp hikes. Easy to see why it was important for the Fed to reinsert a benign long-term inflation outlook. Anyway, the jobs report is just one data point and it needs confirmation in the rest of the data this month as well as next month's report. People were all about the "soft patch" at the beginning of the week so this report should cause a serious reexamination.

At some point between now and August the market will probably have serious doubts as to whether the 30-yr actually comes back. There are also supply constraints until the new bond is a sure thing so if the shorts get too heavy while it is only an idea that could set up quite a squeeze. A decision in August seems to put the new 30's issuance in Nov or Feb.

All this U.S. news has managed to crowd the yuan revaluation out of the news. Asian currencies are still trading strong though. Even though China does not want to reward speculators, the pressure internally are only going to get worse until they revalue. I thought they were coming to grips with that but maybe it takes another couple of months. They would need some help from Japan or Korea to scare the speculators at this point and I don't see much of a cause for that. The dollar also rallied nicely on the back of the jobs data but the theme to me is still European weakness. Gold and silver are focused on USD/EUR rather than JPY/USD. I am not sure why that is.

GM Follow Up - Unleash the Lemming

From Barry Ritholtz:

But give credit to the crafty former greenmailer (recall his M.O. in the 80's). If he wanted to, the 87 year old Kerkorian could have very easily upped his stake, quietly accumulating another 28 million shares or so -- and probably done so on the down low at $27-29.

Instead, he worked the crowd like few others we've seen recently. The guy is old school, and I imagine that in the present highly regulated environment, very few people would have the chutzpah to do what Kerkorian did. Hey, I question the motives of anyone who shouts "I BID $31 FOR GM" -- at $26 -- when they are already long 22 million shares. That's rather suspect. But you gotta admire the sheer audacity (in another era, it was called "balls") of the manuever.

That said, its a function of how oversold the market was -- and how many lemmings reside on Wall Street -- that equities reacted the way it did.

Yesterday I threw out the General Motors (GM) news as a reason to buy the markets though I agree with Barry's thoughts 100%. Kerkorian's deal emphasizes style and short-term impact while raising his entry price. At $31 Kerkorian not only bid through the offer, but bid through the closest resistance and into a big gap. The trade screams "technically driven" while the company's fundemental problems with unions and pensioners remain unsolved. Barry also notes the oversold state of the tape as the reason for lemming-like behavior in the market at large. As I was/am a lemming I thought I would elaborate.

A week ago banks faced difficulty selling a $3 bln bridge loan for the Sungard transaction. I wrote, "It will only take one good deal to create a bounce in this environment..." and that is the logic for jumping in. The markets were being starved of capital and Kerkorian stepped up to provide some. His money alone didn't do it but it could shift psychology enough to lower risk premiums and induce investment again. A very short-term effect but given the length of time we spent bottoming in the last couple of weeks I would say it lasts a month.

Anyway, to be or not to be a lemming is all about how quickly you can turn your portfolio around. For me it is a few minutes to reverse my index exposure. Kerkorian has caused a trading bounce and I am trading. Knock on wood I guess...

Aman Capital Management Faces Big Losses

From the FT ($$):

One of Singapore's biggest hedge funds is thought to be facing significant derivatives trading losses, following the resignation of one of its main fund managers.

Aman Capital Management on Wednesday confirmed that its $242m hedge fund had suffered "trading losses in April", which have raised concerns about its internal risk controls.

The company also confirmed the departure of Michael Syn, a former derivatives specialist at UBS, the Swiss banking group.

A company official declined to comment on the likely cause and extent of the trading losses, pointing to an "independent review" launched by the fund's administrator, or back-office services provider, at the end of last week.

However, industry experts believe the fund may have lost more than $43m, or 18 per cent of its assets, in April by investing in derivatives based on the Korea Composite Stock Price Index.

Oye, I viewed the mild volatility increase in April as a needed shot in the arm to active managers but apparently not.

Stephen Jen's Opinion on the Yuan

From Bloomberg:

``People should take advantage of these levels'' and sell the won and Taiwan dollar, said Jen, head of global currency research in London at Morgan Stanley. ``This is not the time to put on the China revaluation trade. China is not ready'' and probably won't revalue the yuan before the end of June, he said.
Investors should sell the Korean won until it weakens to about 1,015 per dollar from 999.80 at 3 p.m. in Seoul, said Jen. The Taiwan dollar could drop to NT$32 versus the U.S. currency, from NT$31.19 at 4 p.m. in Taipei, he said.

General Glut on the New 30-year

He really read my mind with this one:

As I type the 10-year is up to 4.23%, rising over 1% today. Now this is still nothing compared to where it was in late March (~4.6%), but one has to wonder if the ultra-low ten-year yields can last with the 30-year on the way. And more importantly, what will this do to mortgage rates which tend to move in tandem with the 10-year? After all, it was late March when the 30-year FRM topped 6.0% for the first time since July 2004.

A while back Brad Setser pointed out the tight supply of U.S. long maturity debt as a reason for the yield curves flatness and I commented:

While the limited supply of long-maturity bonds is an interesting data point I am not sure it explains a whole lot about the low yields. There has been no supply limit on the corporate side of debt issuance.
If the restricted supply of treasuries is keeping yields down then corporate spreads should be wide and not historically tight as they are. Maybe it is a second tier effect of some sort where the low treasury yields create the illusion of stability which leads to spread tightening but that is bit tougher to believe.
Probably easier just to say that bond investors expect inflation to remain low for a long time.

Sitting here today I was probably wrong and Brad was right. My comment puts way too much faith in the capacity of investors to act rationally and widen out spreads as non-UST debt grew.

I did not show up today with bond shorts on but have been looking for steepening (and been wrong) for quite a while. I am not planning to chase yields here and expect some retracement of this mornings move. Unless the Treasury announces in August that we don't need a long bond after all, this announcement looks like a green light to sell the long end of the yield curve.

A New Long Bond on the Horizon

From CBS Marketwatch:

"We will examine if we have the flexibility to issue 30-year bonds while maintaining deep and liquid markets in our other securities and determine if nominal bond issuance is cost effective," said Timothy Bitsberger, assistant secretary for financial markets.

Treasury will announce a decision about issuing the 30-year bond on Aug. 3. If reinstituted, the bond could be sold again in February 2006. Read the report.

I guess (like Greenspan) the government is finally acknowledging the budget surplus might not be here to stay. Kind of a head slapper that this was on the horizon, now that it is out there.

They probably could have picked a better day to announce this than after the FOMC misprint. While I am not a big believer that supply has any lasting impact on the level of interest rates, when they announced the end to 30-year issues the yield on the long bond fell 40 bps in 2 days.

Another Reason to Own this Rally

From the AP:

Kirk Kerkorian's Tracinda Corp. is offering to pay about $870 million for a nearly 5 percent stake in General Motors Corp. in a deal that would boost the billionaire investor's stake in the world's biggest automaker to nearly 9 percent.

Tracinda said in a statement Wednesday that it was offering to buy 28 million shares, or 4.95 percent, of GM stock at $31 a share in cash, an 11.6 percent premium over GM's closing stock price on Tuesday.

It said the proposed purchase was for investment purposes only.

GM shares jumped $1.83, or 6.6 percent, to $29.60 in premarket activity. A message seeking comment was left with GM.

The earnings miss by GM was at the heart of recent market weakness which adds a lot of importance to this news in my view.

European Gold Sales?

The Prudent Investor mentions an interesting change in the gold accounts of Eurosystem:

Gold bugs won't like this piece of news. Two Central banks of the Euro system took advantage of the high gold price and sold about 54 tons of gold last week, based on an assumed gold price of 435 dollars per ounce. According to the latest consolidated weekly financial statement of the Eurosystem, the position "gold and gold receivables" shrank 528 million Euros or 0.41 percent to 127,431 billion Euros. This contradicts a former ECB statement that had claimed the central bank would abstain from further gold sales until September 26, 2005.
In a press release from March 31 the ECB had said it "has completed a programme of gold sales amounting to 47 tons of gold. These sales are in full conformity with the Central Banks' Gold Agreement, dated 27 September 2004, of which the ECB is a signatory. It is not the ECB's intention to sell more gold for the first year of the agreement, starting on 27 September 2004 and ending on 26 September 2005."

I am not sure if I am a "goldbug" but I am long. I thought this news was alright. Afterall, If gold can hold up in the face of government selling while the dollar stages its best rally in a year then why sell it?

Delayed Reaction

So the Fed accidentally forgot to mention that longer-term inflation expectations remain well contained (original here, new here). That revision appears to be responsible for the jump in TLT and QQQQ into the close. It also weakened the dollar a bit.

Housing stocks could end up the big winner as they didn't like the original statement while the mining stocks anticipated the dollar weakness pretty well. The mining stocks have been sold off hard lately so the rally might not have had much to do with the news.

I thought the original statement fit my morning thesis alright but the new one obviously fits better.

I imagine the statement change will make for a lot of chatter tomorrow. To me the two statements have the same meaning but I guess that is because I see the growth slowdown (lower oil, copper, and steel prices) relieving inflation pressures. I almost went on a rampage this AM about the silliness the Fed locks itself into trying to use language to convey future probabilities to the markets. Given the concerns they have about guiding the market it would be a lot easier just to publish a table of future rate moves and expected probabilities.

Fed Day

Mark Thoma put up a very interesting piece on what to expect out of the FOMC meeting a few days back. The gist was that the Fed will error towards tight money until Greenspan leaves to insure that inflation expectations remain low for his successor. That makes a lot of sense but it won't be much fun politically. It also talks a bit about the word "measured" and whether it stays or goes. My feeling on this is that last meeting's statement kept "measured" but led the market to foresee a 50 bp hike, making the word irrelevant.

The meeting minutes strengthened this view as the committee members dedicated a large amount of time to worrying that "measured" was being misinterpreted. The markets had been very clear that "measured" meant 25 bps at the next meeting but with the internal debate demonstrating unhappiness with such consensus the market will be more than happy to think something else or ignore the term altogether. More than a debate over the language the minutes indicated the committee is having a tougher time seeing 1-2 meetings ahead. I think it also indicated a widening spread of opinion about the balance of risks.

I would guess the statement today reflects more balance than the last one did and probably continued policy uncertainty. I would be surprised if they don't mention increased signs of weakness internationally and relief from commodity prices. Those statements will be weighed against the stronger inflation data and continued strength in housing. The data seems to have shifted away from growth and inflation since the last meeting. Anyway it will be 25 bps now and 25 bps expected for June but I bet more people begin looking for a pause thereafter.

That may be good news for domestic markets but I don't think dollar bulls will love it. I would guess we get more weakness against Asian currencies.

Following Up on Gold Spreads

From CBS Marketwatch:

What has happened recently in gold shares is a microcosm of this. Gold is up 8% since the November 2004 peak in the HUI - yet the index is 30% lower.
Reading the company results, the reasons are obvious: explosions in oil and steel costs, and a surge in commodity currencies, indirectly a comment on the curious way gold has lagged overall price changes recently.
In other words, gold shares may have detached from their normal tracking of the gold price for legitimate, if unpleasant, reasons of their own.
Some feel this has gone too far. James Turk has a chart showing that the Gold/XAU ratio has only been lower - slightly - in the last couple of desperate bear markets.
Taking the view that extreme unhealthiness in the gold mining industry signifies a bottom, Turk thinks this could be encouraging.
Others might prefer to follow the Gartman Letter's example and shelter in the new Bullion ETFs, GLD (GLD: news, chart, profile) or IAV (IAV: news, chart, profile) .

So if gold prices stay strong while steel and oil prices fall, the spread should close again right?

Another Interesting Fed Critique

From the FT ($$):

As early as the late 1990s, Federal Reserve officials from Alan Greenspan, the chairman, down have warned that the US external deficit is unsustainable. The Fed should be applauded for its analysis of the issues. But too many Fed officials are cheerleaders for the view that adjustment will be smooth.Even if one is confident that this will be the case, it is another matter to assert that a correction of the US external deficit will probably be benign in its effects on financial markets.

The Federal Reserve has been disingenuous in not stating that adjustment will require that the growth of total domestic demand - principally consumption and investment - slows dramatically. Assume that the US current account deficit will be halved over the next three to five years from its current 6 per cent of gross domestic product to 3 per cent. To accomplish this, the growth of demand - 4.4 per cent over the past year, and three-quarters of a percentage point faster than the 3.6 per cent growth of domestic output (GDP) - will have to be reduced by about 2 percentage points to three-quarters of a percentage point below the trend growth of potential output, which is about 3.2 per cent. In other words, to about 2.5 per cent or less.

This slowdown translates to $1,350 for every woman, man and child in the US. And the inevitable adjustment of dollar exchange rates, in the order of 30 per cent on average, will add an extra $1,000 per capita due to the adverse effects on the US terms of trade. The average price of US imports will rise relative to the average price of exports. No wonder politicians are staying away from this issue. The Federal Reserve does not have that excuse.

I don't think the Federal Reserve is going to take it upon themselves to half the current account deficit in 3-5 years but the foreign exchange market might.