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     Dec 9, '13

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The tapering countdown
Commentary and weekly watch by Doug Noland

This from Bloomberg's Saijel Kishan and Kelly Bit on December 6: "The $2.5 trillion hedge-fund industry, whose money managers are among the finance world's highest paid, is headed for its worst annual performance relative to US stocks since at least 2005. The funds returned 7.1% in 2013 through November ... That's 22 percentage points less than the 29.1% return of the Standard & Poor's 500 Index, with reinvested dividends, as markets rallied to records. ‘It has been difficult for hedge funds on the short side,' said Nick Markola, head of research at Fieldpoint Private, a $3.5 billion ... private bank and wealth-advisory firm

"... Hedge funds, which stand to earn about $50 billion in management fees this year based on industrywide assets, are

underperforming the benchmark US index for the fifth year in a row ... Billionaire Stan Druckenmiller, who produced annual returns averaging 30% for more than two decades, last month called the industry's results a ‘tragedy' and questioned why investors pay hedge-fund fees for annual gains closer to 8%."

Let's talk the markets. There are now only about three weeks to go to wrap up an extraordinary 2013. One wouldn't think the calendar should be much of an issue for the markets. Yet market closing prices on Tuesday, December 31st, will determine the compensation for thousands of hedge funds that control trillions of positions (not to mention year-end bonuses for tens of thousands of market professionals worldwide).

The traditional standard has been that hedge fund operators take 20% of a fund's return for the year. Often it's a case of receiving a cash payment for "paper" (unrealized) portfolio gains. For a decent number of funds, market performance over the coming three weeks will significantly impact 2013 returns. A major move in the markets might prove a case of life or death for struggling firms. For the fortunate ones, a big year ensures financial security for years to come. 2013 market gains will add to the already inflated number of global billionaires.

As noted in the Bloomberg article above, hedge fund industry returns have struggled again this year. Shorting stocks has been a nightmare. Long exposure in precious metals and commodities has been a nightmare. Playing the emerging markets (EM) has been dashing through minefields. In general, global fixed income has been tough. It's not that much of an exaggeration to say equities have been the only game in town. Yet the yen short and yen "carry trades" (borrow/short yen and use proceeds to buy higher-yielding securities) have been huge winners. European periphery debt has also provided strong returns. But, basically, there's just way too much (and growing) "money" chasing securities markets and mucking up the traditional game of market speculation.

Within the hedge fund community, there's an unusually wide dispersion of performance. Some of the big "global macro" funds hit home runs with the central bank liquidity trade - short the yen and go long equities. At the same time, a notable percentage of funds have posted only modestly positive returns for the year. And, I'll presume, there are an unusually large number of fund managers that have been pulled into the long European debt and global equities trades with a sense of trepidation. To be sure, it's been a year where trend-following and performance-chasing dynamics attained unstoppable momentum.

Friday's trading bolstered the consensus view that equities are poised for a strong year-end mark up. I have posited that the backdrop creates the potential for the emergence of a lot of weak-handed traders in the event of an unexpected market reversal. Fortunate managers might want to lock in their big years, while many others could be forced to impose aggressive risk management to safeguard evaporating 2013 gains.

Over recent weeks, market dynamics have unfolded that seemed to increase the probability of an unexpected bout of "risk-off" trading. In a replay of the May/June Dynamic, global yields have been on the rise. After declining to a low of 2.50% in late-October, 10-year Treasury yields ended Thursday at 2.85% - not far from the 3.0% level from early-September.

Last week saw the MSCI Asian Pacific equities index drop 1.8%, the biggest decline since August. Australia's main equities index was hit for 2.5% and New Zealand stocks were down 1.7%. Australian 10-year bond yields jumped 21 bps last week to a 25-month high 4.44%. Singapore stocks fell 2.0%, and South Korea's Kospi sank 3.2%. Turkey's major equities index fell 3.1% last week. Argentina's Merval stock index was hammered for 6.77%.

EM instability has returned - in some cases with a vengeance. Brazilian (real) yields closed Wednesday at a multi-year high 13.27%, up 190 bps from early September lows. Other EM problem children also saw bond yields spike higher. Indonesian 10-year yields ended the week at 8.64%, up from the October low of 7.0% and not far from September highs (8.93%). Indonesian yields began the year at 5.19%. The Ukraine has become another EM worry.

Ukraine's dollar yields jumped from 9.40% on November 25th to 10.38% on December 3rd (after trading at 6.86% in early-March). After ending October at 7.16%, Russian (ruble) yields jumped last week above 7.90%. After trading down to 8.20% in late-October, Turkey's 10-year sovereign yields last week returned to 9.60%. South Africa saw 10-year yields jump from October lows of 7.30% to above 8.10% last week. Almost across the board, EM yields have risen over recent weeks.

This quietly emerging "risk off" backdrop took an interesting turn last week in Europe. Curiously, French 10-year yields surged 29 bps to 2.44%, the highest level since September. French debt has been a speculator community darling. Perhaps there is a large yen "carry trade" component in the French bond market. Shorting German bunds to lever in higher-yielding French debt has definitely been a huge winning trade - although less so after spreads widened a notable 14 bps last week. Italian and Spanish debt have also been 2013 winners, although these gains were also under pressure last week. Friday's bond rally reduced what were mounting early-week losses in periphery European bond markets.

However, Friday's equities rally didn't make much headway on notable losses in European equities. Italian stocks were slammed for 4.7% last week, taking back about 30% of Borsa Italiana's 2013 gain (11.4%) in only five sessions. Spanish stocks' 4.4% drop cut year-to-date gains to 15.1%. The French CAC40 sank 3.9% (up 13.4% y-t-d), and Germany's DAX fell 2.5% (up 20.5%). It's worth noting that Financials led European stocks lower last week. And Friday from Bloomberg: "Corporate Bonds Suffer Biggest Weekly Loss Since June in Europe."

European Central Bank president Mario Draghi made an interesting comment during his post-meeting press conference: "If we are to do an operation similar to the LTRO ["long-term refinancing operations" - the ECB's preferred liquidity-bolstering measure] we want to be sure it's being used for the economy and that it's not going to be used to subsidize capital formation for the banking system through carry trades."

The "Draghi Plan" has proved a huge boon for speculators in periphery (particularly Greek, Portuguese, Italian and Spanish) bonds. Perhaps Draghi's comment last week suggests the ECB is increasingly concerned about mounting speculative excess. A downside of the ECB backstopping European debt has been the huge speculative inflows that have boosted the euro currency at the expense of struggling periphery economies. The ECB is now in a difficult spot. It would prefer a weaker currency, but dovish talk at this point only feeds a speculative Bubble.

Here at home, the Fed as well confronts dysfunctional speculative dynamics. QE has fueled a year-to-date 29.1% total return in the S&P 500, with the small cap Russell 2000 and the S&P400 Midcaps returning 34.8% and 30.0%. Yet Treasury and MBS yields have marched higher in the face of the Fed's trillion dollar bond market liquidity injection operation. In spite of the Fed and Bank of Japan's combined $160 billion (or so) of monthly liquidity injections, global yields for the most part have jumped higher.

Thus far, cracks in the "periphery" of the global bubble have only worked to bolster excess at the "core" - a destabilizing dynamic fueled by central bank liquidity injections, guarantees and backstops. The global leveraged speculating community has been right in the thick of this dynamic, as they flee underperforming markets to jump aboard inflating speculative bubbles. US equities and corporate debt, along with European stocks and bonds, reside today at the heart of increasingly unwieldy global bubble dynamics.

Friday's stronger-than-expected US non-farm payroll data add an exclamation point to what has been a batch of strong data. With surging stock prices, inflating home prices and about the loosest corporate credit conditions imaginable, it would be surprising if the economy weren't picking up some momentum. As such, our central bank is bringing new meaning to "behind the curve". The case for further delays in tapering gets only weaker by the week.

If the Fed doesn't begin articulating its tapering strategy on December 18, it surely will by January 29. This would suggest ongoing "risk off" for the troubled periphery - especially the "periphery of the periphery" of troubled emerging markets. And after the way equities responded to the Fed's retreat from September tapering, I expect Fed officials will be more hesitant to pamper a speculative marketplace next time around.

How will the global leveraged speculators game this? Play for further "how crazy do things get" speculative excess at the "core"? Push the melt-up dynamic in US equities for all it's worth - squeezing the shorts and hedgers at each and every opportunity? Or does the unfolding "risk off" dynamic continue to expand, as was the case for much of last week? Are we in the early stages of a problematic de-leveraging throughout global fixed income, a predicament exacerbated by ongoing bubbles in "core" equities and corporate debt?

As the marginal source of buying and selling pressure in many global markets, the now $2.5 trillion hedge fund industry will undoubtedly set the tone. If the hedge funds get through year-end, they will then have January to contend with. They surely would like to avoid having to de-risk into a June-like backdrop of heavy mutual fund and ETF outflows. The current backdrop would seem to imply the return of unstable markets for some weeks to come.

: The S&P500 was unchanged (up 26.6% y-t-d), while the Dow declined 0.4% (up 22.3%). The Utilities gained 0.9% (up 7.3%). The Banks slipped 0.5% (up 31.5%), while the Broker/Dealers were little changed (up 63.5%). The Morgan Stanley Cyclicals were down 1.6% (up 34.6%), and the Transports dipped 0.5% (up 35.7%). The S&P 400 Midcaps gained 0.4% (up 28.4%), while the small cap Russell 2000 declined 1.0% (up 33.2%). The Nasdaq100 increased 0.5% (up 31.7%), and the Morgan Stanley High Tech index gained 0.7% (up 27.5%). The Semiconductors advanced 1.1% (up 34.3%). The Biotechs fell 1.1% (up 47.8%). With bullion down $24, the HUI gold index sank 7.8% (down 56.6%).

One-month Treasury bill rates ended the week at 2 bps, and three-month rates closed at 6 bps. Two-year government yields were up 2 bps to 0.30%. Five-year T-note yields ended the week 12 bps higher at 1.49%. Ten-year yields rose 11 bps to 2.86%. Long bond yields increased 8 bps to 3.89%. Benchmark Fannie MBS yields gained 8 bps to 3.52%. The spread between benchmark MBS and 10-year Treasury yields narrowed 3 bps to 66 bps. The implied yield on December 2014 eurodollar futures was little changed at 0.355%. The two-year dollar swap spread was little changed at 10 bps, while the 10-year swap spread declined 2 to 7 bps. Corporate bond spreads were little changed on the week. An index of investment grade bond risk was unchanged at 70 bps. An index of junk bond risk increased 2 to 341 bps. An index of emerging market (EM) debt risk declined 2 bps to 332 bps.

Debt issuance picked right back up. Investment grade issuers included Johnson & Johnson $3.5bn, CVS Caremark $3.25bn, Thermo Fisher Scientific $3.2bn, Microsoft $2.0bn, American Honda Finance $1.0bn, New York Life Global $750 million, Starbucks $750 million, Alcatel-Lucent USA $650 million, Xerox $500 million, Nordstrom $400 million, Genworth $400 million, AvalonBay Communities $350 million, Federal Realty Investment Trust $300 million, Alabama Power $300 million, Ameren Illinois $800 million, PACCAR $250 million, TTX $250 million, Retail Opportunity Investments $250 million and Mizuho Securities $100 million.

Junk bond funds saw outflows of $141 million. Junk issuers included Forest Labs $1.2bn, NCR $1.1bn, Ally Financial $1.0bn, Alphabet Holding $450 million, Consolidated Containers $250 million, Proofpoint $201 million, Headwaters $150 million, Regis $120 million and HudBay Minerals $100 million.

Last week's convertible debt issuers included RPM International $200 million, Orexigen Therapeutics $125 million, HCI Group $100 million and Endologix $75 million.

International dollar debt issuers included BNP Paribas $2.5bn, Credit Suisse $2.25bn, Commercial Bank Australia $1.5bn, BPCE $1.25bn, Altice $1.1bn, Beverage Packaging Holdings $590 million, Dexia $600 million, Ultra Petroleum $450 million, Abengoa Finance $450 million, Turkiye Bankasi $400 million, Aircastle $400 million, Pacnet $350 million, Fly Leasing $350 million and Export Development Canada $100 million.

Ten-year Portuguese yields jumped 15 bps to 5.94% (down 81bps y-t-d). Italian 10-yr yields rose 12 bps to 4.17% (down 33bps). Spain's 10-year yields increased 5 bps to 4.17% (down 110bps). German bund yields jumped 15 bps to 1.84% (up 52bps). French yields surged 29 bps to 2.44% (up 44bps). The French to German 10-year bond spread widened 14 to a 14-week high 60 bps. Greek 10-year note yields were up 13 bps to 8.71% (down 177bps). U.K. 10-year gilt yields jumped 13 bps to 2.90% (up 108bps).

Japan's Nikkei equities index declined 2.3% (up 47.2% y-t-d). Japanese 10-year "JGB" yields were 6 bps higher to 0.66% (down 12bps). The German DAX equities index fell 2.5% (up 20.5%). Spain's IBEX 35 equities index was hit for 4.4% (up 15.1%). Italy's FTSE MIB sank 4.7% (up 11.4%). Emerging markets were mostly lower. Brazil's Bovespa index dropped 2.9% (down 16.4%), and Mexico's Bolsa declined 1.4% (down 4.1%). South Korea's Kospi index sank 3.2% (down 0.8%). India's Sensex equities index rose 1.0% (up 8.1%). China's Shanghai Exchange gained 0.8% (down 1.4%).

Freddie Mac 30-year fixed mortgage rates jumped 17 bps to an 11-week high 4.46% (up 112bps y-o-y). Fifteen-year fixed rates surged 17 bps to 3.47% (up 80bps). One-year ARM rates dipped a basis point to 2.59% (up 4bps ). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates jumping 8 bps to 4.53% (up 50bps).

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