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     Feb 19, '13


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CREDIT BUBBLE BULLETIN
Japan's wild hedge fund ride
Commentary and weekly watch by Doug Noland

I posited that Mario Draghi this past summer "singlehandedly" altered the global financial landscape. This miraculous feat was made possible with his bold guarantee of unlimited ECB bond purchases to backstop troubled euro-zone bond markets and system liquidity more generally. As soon as the marketplace became comfortable that his backstop was credible, the "Draghi Plan" fundamentally altered the risk versus reward calculus for holding and shorting European periphery debt.

This abrupt change in debt market perceptions then worked to


reverse the crisis of confidence imperiling the soundness of Europe's banking conglomerates, the region's economic prospects and the euro currency.

Importantly, the global leveraged speculating community was forced to cover short (bearish) positions in Europe - and many reversed course and established long holdings. Illiquidity and capital flight risk were transformed into liquidity abundance and major financial inflows. An impending catalyst for a problematic bout of global de-risking/de-leveraging ("risk off") was quashed. For "global macro" and global risk markets, this proved a game changer.

During bouts of acute financial stress over the past few years, European officials repeatedly protested that they were under the attack of the hedge fund community. It is, then, ironic that the Draghi Plan incentivized leveraged player purchases that boosted marketplace liquidity and dramatically lowered market yields in Spain, Italy, Portugal, Greece and Ireland. Following in the footsteps of the Federal Reserve, to stem Europe's deepening crisis Draghi had to create an enticing backdrop for leveraged speculation.

Last summer's crisis was rapidly becoming a global systemic issue. The global move to more open-ended quantitative easing - especially by the Federal Reserve and Bank of Japan - was part and parcel to a concerted global central bank response to systemic fragilities. And I recall clearly how the Mexican bailout in 1995 emboldened the speculator community and spurred dangerous Bubble excess in South East Asia, Russia and the developing markets throughout 1996. The late-1998 LTCM bailout and Fed reliquefication emboldened the speculators and played an integral role in the 1999 Bubble melt-up in technology stocks and the US equities more generally. I'm monitoring for indications that the "European" bailout might spur a major bout of speculative excesses in 2013.

Granted, a billion dollars just isn't what it used to be. But according to The Wall Street Journal, George Soros' hedge fund "has scored gains of almost $1 billion" shorting the yen over the past few months.

From the WSJ (Gregory Zuckerman and Juliet Chung's "US Funds Score Big by Betting Against the Yen"):
"Some of the biggest US hedge-fund investors have made billions betting against the yen, exploiting Japan's determination to weaken its currency and boost its economy. Wagering against the yen has emerged as the hottest trade on Wall Street over the past three months… The growing trade has itself helped pressure the yen, which has slid almost 20% in about four months. That, in turn, is helping fuel what could become a world-wide currency war. Countries such as Germany and France have criticized Japan's policies, while others have threatened to take action to reduce the value of their own currencies to remain competitive with Japan."
And from the Financial Times (Sam Jones and Dan McCrum's "'Abe Trade' Revives Macro Hedge Funds"):
"Shorting yen and buying Japanese equities, inspired by the dovish monetary bent of Japan's new prime minister, Shinzo Abe, has been one of the most successful hedge fund wagers in years. And many believe it is a harbinger of greater macroeconomic dislocations and greater opportunities. Since 2010, the blue-bloods of the world's $2tn hedge fund industry - so-called global macro managers - have been cowed by rangebound markets that have been dominated by choppy 'risk on, risk off' movements. Global macro stars, who specialize in trading interest rates, bonds and currencies to play the ups and downs of the world economy have not just struggled to make money, they have struggled not to lose it."
I posed the question last week, in "New Bull or Bigger Risk On, Risk Off?", Europe fragilities were instrumental in the "choppy 'risk on, risk off' movements" throughout global markets over the past two years. This highly unsettled backdrop forced the big macro hedge funds - and traders/speculators more generally - to keep trades on short leashes (risk control measures that chipped away at performance). We now see indications that the big players have been unleashed, at least as far as taking - and winning - huge bets against the yen.

More from the FT:
"For many of them, the prospect of 'currency wars' and a breakdown in the international economic consensus will make for the kind of investment opportunities they have been desperate for since 2008. The next few months are rich with potential opportunities, they believe, whether shorting sterling in anticipation of laxer monetary policy…; buying up equities to trade on institutional investors' rotation away from bonds; or investing in commodities such as palladium to capitalize on a race for devaluation among the world's big currencies. 'I think it's the rebirth of global macro,' says the head of one of the world's top five global macro hedge funds. 'For the last three years we have had this rangebound environment, and now it looks like individual currency actions, individual countries acting, are going to start to dominate.'"
The "rebirth of global macro"? "Greater macroeconomic dislocations and greater opportunities"? There are different angles of the analysis to contemplate. First of all, we're seeing important confirmation in the thesis that heightened global fragilities and aggressive policymaker responses have incited only more aggressive risk-taking. There is, as well, support for the view that currency markets have become a key battleground for the speculator community. Policy measures have been unprecedented - and I would argue Bubble excesses have been commensurate. With the euro situation seemingly stabilized in the short-term, the backdrop became ripe for a big bet against the yen. And with the new Abe government supportive of aggressive Bank of Japan money printing and a weaker currency, some of the "community" of big funds pounced.

The bearish yen trade has been a big winner. Will the speculators pile on? Will proceeds from yen selling provide liquidity for bullish "risk on" market bets globally? Could indiscriminate selling potentially risk inciting a freefall in the yen? If yen weakness turns disorderly, could this negatively impact Japan's vulnerable bond market? Or could developments elsewhere (Europe?) shift the backdrop away from today's global "risk on," in the process inciting an abrupt reversal in the yen and another painful short squeeze?

This yen situation has potential to be an integral facet of a "Bigger Risk On, Risk Off" global market dynamic.

From a "risk on" perspective, the big macro funds holding onto gains would ensure that they'd be on the receiving end of fund inflows. They would enjoy greater firepower - and confidence - for which to pursue bigger macro bets. And their success would have the leveraged speculating community and global traders alike determined/desperate to participate in the next big trade. The big win on the yen could have important financial and psychological ramifications for an expanding global Bubble backdrop.

Lurking Big Risk Off is a potential consequence of unfolding Big Risk On. The Europeans today have no qualms with the global leveraged speculators actively buying their bonds. But many are increasingly frustrated by the strong euro - and they'll be mad as hell again when the speculators start liquidating and shorting their debt. The Japanese are these days fine with the hedge funds pushing the yen lower. Yet with Japan's stupendous debt load, it brings to mind the old "be careful what you wish for." An attack on Japanese bonds would be problematic.

Meanwhile, much of the world is increasingly fretting "currency wars" and "competitive devaluations." No one seems to have an issue when speculators bid up stock and bond prices. Increasingly in the currency markets, however, countries are looking at the situation as a zero sum game. "Developing" policymakers, in particular, are about fed up with "hot money" inflows inflating their currencies. Yet global central banks have created such abundant liquidity conditions that currency speculation seems likely to gain further momentum. In our unstable financial and economic worlds, policy measures have come to dictate currency and risk market behavior. This plays right into the hands of a global pool of speculative finance that - bull market, bear market, crisis or recovery - only seems to inflate larger by the year.

And Friday from Bloomberg: "Billionaires Soros, Bacon Cut Gold Holdings as Price Slumps."

The big hedge funds have been major operators in the gold market. As "risk on" has gained momentum, so-called "safe haven" assets have lost some luster. Gold, Treasury bonds and German bunds have all stumbled in early-2013. And in this trend-following and performance chasing financial landscape, funds are compelled to sell the underperformers and buy what's inflating in price in order to survive. With safe havens out of fashion and cash a total loser, "money" flows freely to the inflating riskier assets. Funds aggressively playing "risk on" attract strong inflows and greater financial power, while those cautiously positioned lose assets and are forced to liquidate lower-risk assets. Meanwhile, buoyant risk markets work wonders on bullish market sentiment.

At the same time, there is also ongoing confirmation that the incredible global policymaking and liquidity backdrop is much more successful in inflating asset markets than it is in boosting economic performance. In particular - and especially considering policy environments - economies in Europe, Japan and the US continue to un-impress. This bolsters the view of a widening global gap between inflating financial asset prices and underlying economic fundamentals.

This begs the question: how might the emboldened "global macro" community play this divergence? Will they play policymaking and the inflating Bubble for all it's worth? Or will they begin to approach speculative markets with a more contrarian bent? With some funds emboldened and still so many others desperate for performance, it seems reasonable to assume that markets become even more speculative - a game of trying to catch folks on the wrong side of trades (ie Apple, gold, etc), underexposed to outperforming sectors (ie homebuilders, high-beta and "short" stocks) and overexposed to the underperforming (ie "defensive").

Most call it a "new bull market". I'll stick with "inflating speculative Bubble".

WEEKLY WATCH
For the week, the S&P500 added 0.1% (up 6.6% y-t-d), while the Dow slipped 0.1% (up 6.7% y-t-d). The broader market outperformed. The S&P 400 MidCaps gained 0.6% (up 9.3%), and the small cap Russell 2000 gained 1.0% (up 8.7%). The Banks increased 0.2% (up 7.5%), and the Broker/Dealers jumped 2.1% (up 15.8%). The Morgan Stanley Cyclicals gained 1.2% (up 8.5%), and Transports increased 0.6% (up 12.1%). The Morgan Stanley Consumer index rose 1.2% (up 9.4%), while the Utilities dipped 0.3% (up 4.1%). The Nasdaq100 declined 0.4% (up 3.9%), while the Morgan Stanley High Tech index added 0.2% (up 6.6%). The Semiconductors gained 0.9% (up 11.6%). The InteractiveWeek Internet index rose 1.0% (up 10.6%). The Biotechs slipped 0.4% (up 8.8%). With bullion slumping $57, the HUI gold index sank 6.0% (down 14.6%).

One-month Treasury bill rates ended the week at 8 bps and 3-month rates closed at 10 bps. Two-year government yields were up about 2 bps to 0.27%. Five-year T-note yields ended the week up 3 bps to 0.86%. Ten-year yields gained 5 bps to 2.00%. Long bond yields added a basis point to 3.18%. Benchmark Fannie MBS yields rose 4 bps to 2.62%. The spread between benchmark MBS and 10-year Treasury yields was about a basis point narrower at 62 bps. The implied yield on December 2014 eurodollar futures increased 2 bps to 0.63%. The two-year dollar swap spread was little changed at 15 bps, while the 10-year swap spread narrowed about 2 to 6 bps. Corporate bond spreads narrowed. An index of investment grade bond risk declined 3 to 87 bps. An index of junk bond risk fell 10 to 438 bps.

Debt issuance was steady. Investment grade issuers included Dupont $2.0bn, Citigroup $1.5bn, Praxair $900 million, Walt Disney $800 million, American Honda Finance $750 million, Discover Bank $750 million, Kellogg $650 million, Airgas $600 million, Arrow Electronics $600 million, Starwood Property Trust $600 million, Emerson Electric $500 million, National Fuel Gas $500 million, and John Hopkins $355 million.

Junk bond funds saw outflows slow to $165 million (from Lipper). Junk issuers included Polyone $600 million, Delphi $800 million, RSI Home Products $525 million, American Axle & Manufacturing $400 million, Triumph Group $375 million, Burlington $350 million, Fairpoint Communications $300 million, Neovia Logistics International $125 million, and Speedy Group $125 million.

Convertible debt issuers included Molina Healthcare $400 million.

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