Oct

30

I was just perusing a "Hedge Fund Monitor (27 Oct)" note from Merrill. It cites Trimtabs research reporting record high hedge fund redemptions in September of $43bn, and says:

Such forced selling drive asset prices lower which in turn creates more losses for HFs and lead to more selling- a vicious circle. …We also think that losses to large prime brokers who provide funding to HFs, may have exacerbated some of the forced selling. While HF returns over the past 12 months are negatively correlated to Financials overall they are positively correlated with investment banks, who are also prime brokers to HFs. Just as HFs' cash needs were rising, funding became more difficult.

The note goes on to comment that a popular hedge fund strategy was to invest in equities with cheap yen and points to the strong correlation between USD/JPY and the S&P, giving us yet another variant of the carry trade.

In this narrative, the move in the USD/JPY is less a result of new flows into yen than it is a consequence of severe hedge fund liquidations that have forced an aggressive unwinding of the equity-yen trade. For what it's worth, the ML note looks to the latest COT data (already stale as it reports positions as of last Tuesday's close) and finds crowded net long speculative positions in USD and JPY, suggesting USD/JPY may have further to go on the downside. It's all interesting reading, and almost everyone seems to agree that these violent moves are the result of forced hands, not of a fair reassessment of fundamentals. A good time for the long-term investor to scale in to global equity markets, perhaps. The other thought I had when reading this report is that while I have been expecting a massive rally in USD/JPY when risk appetite subsides, if the USD and other currencies also have super low interest rates by that time, then the yen could have some competition on its hands as the funding currency of choice.

Phil McDonnell writes: 

In recent days the yen has been incredibly strong. The other notable feature of recent trading is that volatility has been historically high. Since 9/11 this year there have been 30 trading days. Only four of those have shown less than a 1% move in either direction. High change days are the norm, not the exception these days. VIX has been rising and made repeated new highs and still resides at high levels.

To see if there is a relationship between these it is often good to look at correlations between coterminous changes. Some of the more notable coincident correlations over the last three months are:

VIX Yen 71%
VIX TBill 68%
Yen TBill 59%

All these relationships are substantial. From these we can conclude that when investors perceive increased risk the money flees to both tbills and yen.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Riz Din adds:

A couple of additional thoughts on the carry trade:

1. One can imagine another reason why the market has fed off itself on the downside is that the carry trade is itself entwined with volatility. The carry trade thrives in a low volatility environment and it is not so long ago that we were experiencing what some called the Great Moderation, an apparently new era of low volatility in the real and financial economy. In such a world where investors are confident that fx rates will lie somewhere within a tight range x months hence, the attractiveness of the interest rate component of low rate currencies grew massively, and the yen and other low rate currencies became cheap financing vehicles for other investments. Alas, to benefit from these low financing rates these investments would have had to have been unhedged for fx risk, and when volatility spiked up, the perceived cushion of saving provided by the lower interest rates paled in comparison to the daily swings in the fx prices. Add this factor to margin calls, margin calls, redemptions, etc and you have another powerful reason for the recent aggressive, self-perpetuating, forced selling that took place across the markets. Always thinking from the other side, after such a large reversal and cleaning out of carry traders, I wonder if there will be opportunities to put this trade on as volatility heads lower– history could be a guide for those who have access to the data. I hear Iceland is offering 18%.

2. I must be missing something obvious here, and maybe this thought can be easily skewered, but I wonder if this simple explanation can be used to show why the carry trade seems to defy economic theory (uncovered interest rate parity) over prolonged periods, only to eventually come crashing down: If two similar bonds or similar stocks are trading massively apart for no reason, immediate buying of one and selling of the other closes the price gap. The price corrects back very quickly and the opportunity disappears in the blink of a eye (Porsche/VW aside). However, entering in to the fx carry trade by selling the low yielding currency and buying the high yielding currency surely only pulls prices further apart, making the carry trade even more attractive to those who use history as a guide. Is this a self-perpetuating cycle that simply carries prices to unsustainable levels?

Alston Mabry replies:

Can't help but think that it has been the other way around: The carry trade and other cheap money forces were what kept volatility low. The image that comes to mind is the pressure of air inside a big balloon, or water inside a sprinkler system; when the pressure is constant, the system is smooth and stable, but when the pressure slacks off, the system sputters and collapses.


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5 Comments so far

  1. HC on October 27, 2008 9:44 pm

    For $ or JPY to be a funding source a bank must be willing to provide the leverage to speculate with. I don’t see that happening anytime soon. Perhaps I am underestimating the risk appetite of banks but I doubt it.

  2. Matt Johnson on October 29, 2008 12:03 am

    I love FX, I’ve been trading it for a long time, and I’m happy to say I’m a pretty good short term spec. This carry trade has always amazed me, actually, how and why funds do it has amazed me, maybe someone out there can help me understand it a bit better.
    So here goes…
    It is obvious that interest rates vary across countries, and if you ask yourself, how can rates in one country be at 1% and rates in the other country be at 7.5%? What would stop capital from flowing from one country to the next? One might think, I’ll just borrow cheap and loan expensive, and earn the carry, and this will happen until the interest rate differential has disappeared. Of course, this can’t happen, because of the FX risk. Exchange rate risk is what allows interest rate differentials to exist – the ivory tower fellas call it ‘the interest parity theorem’. It says that the hedge, in this case the forward, trades away from spot, just enough to capture the spread in interest rates between the two countries. So if you borrow cheap and loan expensive, and hedge your FX risk, you’re none the richer for it!
    Here’s where I get confused.
    If I borrow cheap, and hedge, I’m none the richer, so why does it matter where I get my funding? Unless of course, I don’t hedge my FX risk, then we’re talking a totally different ball game…

  3. Riz Din on October 29, 2008 7:09 pm

    Hi Matt, it's just as you say. To get the carry benefit from a pure FX-interest rate play, you are exposed to the FX leg of the trade. Uncovered interest rate parity theory is one those 'no free lunch' theories that doesn't hold water on a day to day basis, even over several years in many cases, so many people like to pile in to these trades. Of course, this leads to the currency that's supposed to depreciate (according to the economics) actually appreciating, so the effect is UIP in reverse, a double benefit from both the interest rate differential and an appreciation in the invested currency. More leverage = more gains… until one day, things suddenly go wrong.

  4. Matt Johnson on October 30, 2008 12:16 am

    Thanks Riz!

  5. vniederhoffer on October 30, 2008 7:36 am

    Mr Caravaggio's thoughtful comment should be tested with, for example, multiple time series of foregn exchange rates and interest rate differentials. Is there a point when when foreign exchange is predictable as a function of the extent of its previous move as a function of interest rate differentials? Some nice three way tables would be good. v

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