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Thursday May 12, 2005 - 11:37:50 GMT
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Rising risk good for the dollar?


“If these events [volatility in interest rates and the impact of contra-cyclical monetary policy] were unpredictable, how can we expect the elaborate quantitative devices of risk management to predict them? How can we program into the computer concepts that we cannot program into ourselves, that are even beyond our imaginations?

Peter Bernstein, Against the Gods

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We may have had a mini-breakout in economic good news in the last 24-hours: US deficit declined, German economy improved, oil inventories rose, but make no mistake; the smell of risk is in the air. I think these blurbs from yesterday’s edition of Weldon’s Money Monitor sums it up well:

“Symptomatic of the ‘bigger-picture’ macro-themes we have been discussing for months, if not much longer … an environment where the ‘real’ economy does NOT demand capital, as it continues to become more efficient, keeping the secular trend towards a widening output gap intact …[my emphasis]

• … which allows EXCESSIVE dollar-liquidity to electronically fly around the world, in a macro-hunt-for-yield that continues to intensify.

• The FACT that hedge funds now manage over ONE TRILLION DOLLARS, is testament to this dynamic.

• The FACT that hedge funds attracted a RECORD $27 billion of new capital during the 1Q of this year, is testament.

• The FACT that the number of hedge funds has exploded from 610 (managingonly $39 billion) in 1990, to the currently active funds numbering 7,904, is testament to our theme.

• The FACT that investors POURED over $330 billion into equity and balanced mutual funds last year alone, to take the total mutual fund industry to more than $8.1 trillion, lodged among 8,034 US-based funds … is testament.

• BUT, the RISK is rising. Note commentary from an ‘industry insider’ quoted by Bloomberg …

o … “The recent milestone of $1 trillion in industry assets is further evidence that hedge funds continue to appeal to those investors seeking returns without correlation to equity and bond markets.”

“WITHOUT correlation to stocks and bonds ???”

Yikes! We second Mr. Weldon’s astonishment about any belief the modern hedge fund is not correlated with stocks and bonds. The term “hedge,” to describe most funds operating today, lives in name only. Very few are actually hedged. Most are pure one-way spec vehicles placing bets on stocks and bonds.

Given the number of hedge funds in operation you can’t help thinking—shakeout time! Based on even a modicum of belief in Darwinian winnowing, there cannot possible be that many “good” hedge fund managers in the world. We know the number of managers who think they are good is infinite, but we’ve learned over the years that hubris and longevity in leveraged markets are mutually exclusive.

The winnowing is probable beginning. It is a plausible explanation for the rally in US Treasury bond prices. Take a look at the chart below…


After a strong jobs report on Friday, bonds took a dip that pleased the bears. But all of it and more has been retraced over three days this week—and recent highs were tested yesterday. What is interesting about this chart that we couldn’t seem to square is the open interest levels (red line). Notice that despite the rally in bond prices, open interest has not responded much i.e. it hasn’t risen with the rally in bond prices. It suggests there are still plenty of bond bears that aren’t biting on this move higher.

OK…here’s the point we are leading to…what if all these bond bears capitulate to this trend at the same time—a trend that has hedge fund winnowing as the catalyst? And what if a couple of major hedge funds do come unraveled—of the kind that is stretching their quant models for yield in emerging markets globally?

Shazam! It is one of the major themes we have been talking about for a while as a potential major prop, or leg up, for the dollar higher move that began this year. If you are a regular reader of Currency Currents you have seen the next chart before—we refer to it as, déjà vu again!

Now please bear with us, we have added a couple of things to the chart to make our story sound more plausible. Notice the red line (open interest). Back in early 1998 when Treasury bonds climbed, open interest didn’t move higher in response. We later found out about another famous hedge fund debacle, Long Term Capital Management. Which led to the conclusion the rally in bonds and blow-off to a new high was “risk induced.”


All this to get to the nugget for a currency report; notice the blue line in the chart above, that is the US $ Index. And notice how the dollar rocketed as the risk induced money flowed back into US Treasuries. Is it déjà vu again?

We rest our case your honor!

Jack Crooks
Black Swan Capital


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