Did you feel it?  Yesterday, when the Dow dropped more than 600 points?  Perhaps just a mild rumbling underneath the feet?  Or perhaps actual cries of anguish?  Or a final, muted death moan, somewhere within the forest?

No?  Well even that’s not surprising.  Hedge funds do tend to die amid sounds of silence.  But we’ll wager a pint that yesterday didn’t record just  a single death, but more likely a few hundred deaths in Hedge Land.  Because while we ourselves have maintained a bearish tilt in recent months and for 2011 have tried to leave a good bit more of assets in cash, we could not (nor were we ever likely to) foresee the pace of a selloff on a day like Monday.

And neither could many hedge funds, which is the point.  We have little doubt there are many smart minds concentrated in this sector.  But a price dislocation like Monday’s is still likely to leave lots and lots of smaller hedge funds – despite superior brainpower and uber-sophisticated mathematical models – in deep doo doo, having performed badly in both 2010 and 2011.  The dreaded day of wholesale redemptions draws nigh. 

Along with minnows a few big fish will also be trapped.  In immediate upcoming weeks and months, we shall be little surprised to read in our morning papers a new expose about a spectacular blow-up.  [We have no idea who and no idea in which assets, strategies and structures - though if we had to venture a guess, we'd nominate commodities.]  We think global macro funds will be the most usual suspect, but in a world where excessive liquidity have forced more asset classes to correlate positively, we bet many other strategies will be caught out as well.

To win news space, these exposes are almost invariably about the larger funds.  And often there is an element of rogue-trader or faulty-model or excessive hubris or somesuch element thrown in, that supposedly delivered the final fatal blow.  But the truth for big funds that blow up may not be all that different than for hundreds of small funds that do as well.  Their advertised superiority in investment management is generally based on the same, limited number of mathematical models and trading strategies that these managers learned earlier in their careers.  Such similarity in processes means global macro managers are often bunched into the same trades because all their models are telling them the same thing.  With other assets correlating closely, that means much (but not all) of Hedge Land at any single point in time probably share in common 2/3 to 3/4 of their ideas we’d guess.

And when markets surprise them, which they seem to do with greater and greater frequency in recent years, hedge fund superiority is caught out as a lie because they all get soaked at the same time.  They all get soaked at once because they’re all in roughly similar trades, and all trying to exit at a time when they are the main sellers and there is no one on the other side buying.  Spread the contagion to other strongly correlated assets and you have the recipe for a market meltdown. 

The same logic applies to large interbank trading desks from whence many hedge fund managers sprang (leaving behind hedge fund wannabees).  This is a logical way to interpret the selloff of major bank stocks.  Because although Dodd-Frank is supposedly hastening the exit of proprietary trading there is still probably more proprietary exposure than exists on paper.  In keeping with Buffett’s wry observation that you don’t know who’s naked until the tide washes out, all of us are probably in store for another broad viewing of naked bodies.  It won’t be pornographic but it could be obscene. 

And this time round developed country governments are out of money.  S&P has told us so.  Maybe Europeans will raid their tax-sheltered billions to tie over banks (the rich helping the rich), but that’s about it.  US banks in particular will have to take their lumps the way markets intended:  Fail or be taken over.  And those hundreds of small and not-so-small hedge funds will simply fail. 

And wouldn’t that be grand? 

Short Strategy Thought

With VIX closing at 48 Monday we’re pretty sure we’re in overshoot land.  As said above, we understand the wariness about banks and if you’re even more worried about the economy than we are at present, you’d probably want to steer clear of high tech names, too.  But we think we’re seeing real meat-and-pototoes companies with real franchises that will be around in 2012 and 2013 and lots of cash get beat up as well.  And those seem like the names we’d want to investigate first. 

1.  Step back those of you who fancy yourselves US patriots and/or zealots, because we find ourselves in surprise sympathy with much of the S&P decision. 

First, the S&P press release:

http://tinyurl.com/snppressrls.

Stuff we agreed with:

1. For traders, S&P strongly hints AA+ won’t magically change back to AAA for some years to come – so it’s done, get over it.
2. And of course the 23:59 debt-ceiling compromise doesn’t go nearly far enough to stabilize the American government debt-GDP ratio.  We knew that; or should have.
3. S&P wasn’t setting an unreasonable, unrealistic high bar – they just wanted the debt-ratio stabilized by 2150.
4. S&P’s downside scenario – which introduces only slightly less favorable macroeconomic outcomes than its baseline assumptions (see below) – basically suggests the US will face its own Greek day of reckoning sometime before 2015.

But also stuff we disagreed with:

1. S&P said it previously had higher hopes of bipartisan resolve in reining in spending and/or raising revenues; really?
2. Trend real US growth of 3% a year in the coming decade.  This is a very key risk if there’s an undershoot.  S&P’s downside scenario (see above) assumes only slightly slower 2.5% real growth, based on a judgment that nations climbing out of financial crises see persistently below-trend demand growth (recently highlighted in work by Reinhart and Rogoff).
3. Sure Washington is broken (aside:  it’s not broke yet by a long shot).  S&P was correct when it emphasized that political will is an important part of whether a nation is willing to pay (after the LDC debt crisis put paid to Walter Wriston’s enormously erroneous judgment then that nations can’t go broke).  It’s nothing different than what it’s been saying to developing countries for years.  US political will can change when the country is forced to act.  In the event of an actual, full-blown US sovereign credit crisis, we have little doubt Washington will then operate differently.  We harbor hopes that market discipline now will force cynical Beltway hands to operate more intelligently for the common good, before markets throw in the towel altogether.

There’s considerable more uncertainty that needs to be resolved Monday when S&P will release the implications of its sovereign downgrade on the ratings of funds, government entities, financial institutions, insurance companies, public finance and structured products – in other words, the whole blasted financial market.  This could turn very quickly sour the nibbles (small buys) we made in equity markets Thursday and Friday, but no matter, there is a far larger development afoot of more importance for investing and possibly even for history.  We’ll keep our buys but judging by the response of the Tel Aviv stock market, they could hurt.

2. The Empire Strikes Back.  You all should know all about the US Treasury sniping about S&P’s supposed $2trn mistake.  See, eg,

http://tinyurl.com/treasurystrikesback.

1. If you’re going to write a credible riposte to S&P onto a global stage, you might want to make sure your punctuation marks and grammar are correct.
2. Even after the Treasury correction, S&P’s 2021 US debt-to-GDP baseline projection is 85% (less than what appears – from Treasury’s graph – of a number North of 90% in S&P’s original press release).  But Treasury, 85% is still a hocking (shocking, even) big number!

3. A 5,000 year perspective on credit, debt and the downgrade:

http://tinyurl.com/graeberblogpost.

An ex-Wall Streeter’s response?

1. First, a smirk.
2. Then, a tear; definitely a tear.
3. Finally some resolve (we choose to remain optimists).

Fears of another recession continue to grow.

But first off we’re going to take intermediate profit on our short Aussie dollar recommendation, entered Wednesday at 1.0690 and exited today at 1.0458 indicative (10:34am in Sydney), for a 2.15% profit inclusive of the carry we were paying away.

We still believe our back-to-parity target against the greenback is reasonable in a global slowdown, and the long Aussie dollar trade remains crowded even after the recent sell-off we’d guess.

Nonetheless yesterday’s global selloff means there’s now a lot of fear in markets so for up to a few days, we would not be surprised to see some sort of technical rally [full disclosure: yesterday we nibbled by buying a very small long position in the MSCI EAFE index].  Consensus expectations for US July nonfarm payrolls is reportedly +89k, but after the mood-altering gyrations of this week we’d bet it’s lower.  Even a significantly negative print (say, -100k) may not be all that different from where markets have priced, and a small positive print (but below +89k) could even be taken as good news.

We mentioned Wednesday the main risk to our trade would be the Fed undertaking QE3, and near-term romancing of this also distorts the very short-term (ie, the next 2-3 days) risk-reward for the Aussie trade.  But – despite the Wall Street Journal’s manufactured story Wednesday quoting three well-respected but former Fed officials (Fed policy is still made by the living the last time we checked) – we still think the FOMC is hardly lined up for a shift just yet.  We think it’s possible some provocative academic might make the QE3 suggestion at the Jackson Hole conference but don’t think the FOMC will quickly make up its mind.

Two Days Hence

Another light economic data day Monday but we’ll examine Japanese June current account data for more clues about the extent of Japan’s external supply recovery.  In the five months since the Tohoku Earthquake, we think Japan has stabilized but the pace of recovery is slower than what the most bullish prognosticators had expected.   The key challenge is to understand why?

We also suspect that July foreign reserve figures released by various EM countries at the start of the month will show a slowdown in capital flows to the developing world.

Sell AUD/USD, indicating at 1.0690 one minute past noon in Sydney; target parity with the US dollar; stop at 1.0800.

Rationale

We have flagged for a few weeks dangers of a US and global slowdown that now finally seems in the center of market attentions.  Despite a sharp sell-off overnight in risky assets we do not believe we are done with the selling.  We view the Australian Dollar as one of the most sensitive risk assets in the world to growth and so sell it as a hedge to existing risk positions.  On Friday the Reserve Bank of Australia will revise growth forecasts and given the emphases contained in the monetary policy statement released yesterday the delta will likely veer toward slower growth Down Under.  The China Iron and Steel Association also forecasted slower steel demand in China for the second half of the year, a result almost instantly pooh-poohed by the professional commodity markets.  But since CISA is no longer posturing to try to influence annual steel contract prices, we suspect there may be more of a grain of truth in these forecasts than is appreciated by Aussie dollar analysts. 

Risks

The major threat to this trade comes if the US Federal Reserve succumbed to political and market pressures for a third round of quantitative easing, which should almost surely send the greenback lower against most other currencies including the Aussie.  But Fed speakers have indicated over the past two months the bar to enacting QE3 is high.  With a US Congress tilting more conservatively because of the Tea Party-inspired electoral gains of last Autumn, a Fed that runs even more decisively away from the views of populists like Ron Paul risks finding itself under even greater Congressional scrutiny.  Down Under, there were lots of hints in yesterday’s RBA statement it’d like to stay on hold for at least the coming weeks.  On balance we assume, for our trade to work, that relative monetary policies stay on hold over the coming 2-3 weeks. 

Two Days Hence

A light day for economic data tomorrow but two pieces of (relatively dated) June measurements – German factory orders and Malaysian merchandise trade – should both continue to confirm the global slowing we have seen.  To us, given European sovereign debt travails that appear far from over, the German number is going to be more discouraging and hence more important for traders. 

Since the end of April 2011, the 10-year Bund cash yield has dropped 70bp.  Initially some prescient analysts saw this as capitulation against the idea that the end of QE2 will send bond yields higher.  But further, cumulative drop in this bellwether yield – as we have been arguing – can only be consistent with a European economy that is slowing.  That’s why the IEA released oil from its strategic reserves overnight – for only the third time since 1974 – for fear of a further pullback in the global economy. 

Now watch the buyside, where portfolio managers tend to be heavily drawn from ranks of former company analysts, who are fond of boasting how they don’t really need macroeconomics.  Our view is that equities down 10% is a reasonable response to prospects of slower global growth; and it could always get worse depending on Greece.  Let’s see how many of the micro crowd get this right.  Watch all the fun in your 401(k).

US 10-year Treasury yields are rising in the Asia open ahead of solid durable goods orders expected tonight (see our comment yesterday), but we see this as an opportunity to add to duration.

Two Days Hence

Monday will be a slow data day but what data there is – Greece aside – should be mildly encouraging (and hence against the underlying trend of economic softness we see) with US May personal income/spending probably showing the US consumer is still okay (right now we have more concerns with fixed business investment and US exports to the rest of a slowing world).  Given Chairman Bernanke’s press statements, inflation hawks will pay more attention to core PCE inflation, but that will probably be a relief, too, for equities by staying benign.  All the more reason to add a few more bonds to your portfolio. 

We begin with a contrarian view on what we might label the global food price scourge.  There’s nothing tongue-in-cheek about this.  High food prices are a matter of life and death in the poorest of nations.

But there is something obscene when such an important topic gets hijacked by electoral politics, with Reuters telling us the French agriculture minister is trying to twist G20 arms to get a global agreement on the need for more regulation so his boss, French President  Sarkozy, can look good ahead of next year’s re-election battle.

For risk markets food prices have mattered much in EM – and particularly in Asia – in 2011, as main drivers of headline inflation against which EM central banks have been widely urged to tighten.  We have agreed the levels of many EM interest rate complexes have fallen to far below their natural rates in the wake of the Fed’s QE1 and QE2 campaigns, so we have backed the need to bring them back up.  But it seems increasingly bizarre to keep harping on inflation when the industrial world, to us, seems on the cusp of struggling more with deflation than inflation over the balance of the year. 

That’s probably the best way of interpreting why the US economy is flagging again – economies in the wake of horrendous credit crackups that severely damage their financial infrastructure tend to find it difficult to reflate, and any pause in the reflation effort is likely to mean more downward than upward pressures on growth and prices.  There are simply too many holes left in the balloon to be certain it can rise again.  For Europe, this is a picture of prospect:  If Greek difficulties contaminate and hobble the single currency’s financial infrastructure, deflation and not inflation will be the theme no matter what the ECB thinks at present.

We had heard for a few months from commodity players in the know that harvests and global food prices in 2H11 look distinctly better than YTD.  And in fact, the latest World Bank latest review of commodity prices show continuous downward movement for many agricultural prices.  While week to week there may still be spikes in important grains, overall moderation has been in place for several months but seems to be ignored by markets.  Remember in the current Thai election campaign both sides are promising to shore up rice prices for farmers – precisely because such prices have been sagging.

Markets seem far too fixated on the demand side of the global food picture:  Rising caloric content of Chinese and Indian diets are expected to keep prices high for decades.  But the first and main cardinal rule of agricultural economics is probably:  Farmers are awfully rational actors.  When prices go up, they plant more; and find ways to get more production out of whatever land they can find.  We suspect a supply response may well surprise markets when it comes to food prices for the remainder of the year.

This is a big topic, one to which we will return with more analyses over time.  For now, ignoring trends serves up investment opportunities:  Strategically we are on the lookout for parts of EM rates curves where there has been too much tightening priced in, given our expected moderation in food prices.

Two Days Hence

Trading today might want to keep the following data points of tomorrow in mind:

RBAspeak:  Assistant Governor Lowe.  Since the last development, the RBA minutes, surprised traders by its dovishness, it’s probably time for a more hawkish surprise so Australian economists can change their minds once more.

German IFO:  We were proved right today in that European flash PMIs proved far weaker than expected, as we discussed yesterday.  We would expect German IFO to surprise on the downside tomorrow.  We also expect many European economists to chorus this is no big deal; we don’t agree.

US durable goods are expected to rebound.  To be fair we note not all the global macroeconomic news has been bad – Fedex projections yesterday seemed to indicate a pretty solid global economy but may be tilted by Asia.

Finally we’re still wondering if we can last till 11 July, and for possible bank runs in Greece.

The original scenario behind our relief rally view was that by now we would more or less have the next version of the Greek rescue package in place.  Once again, however, European policymakers frustrated us and markets (justifying their high salaries) by kicking the ball down the road till 11 July, the next finance ministerial by when we are now promised (really) the final details of Greek Rescue version 2.0.

FX markets seem extremely fixated about a next EUR12bn disbursement from the original Greek rescue program, just to avoid default by mid-July.  But to us it’s the next version of the overall package that seems far more consequential.  And here the recent news – despite the relief rally – seems uniformly negative.

As with any EM debt crisis, we must begin with the patient.  Greece has now had 13 months of missing performance targets under its May 2010 program.  That – and this should come as no surprise – suggests it will continue to miss performance targets under any new program as well, no matter what Eurocrats tell us.  This is what we meant when we tweeted about the IMF’s double standards – can you imagine a small African country like Mali getting the same bye as Greece has had?  But when you have nationals running the Fund in order to protect their own banks, well c’est la vie!

We admire Papandreou for the political moves he made, essentially sacrificing personal political ambitions for the good of the country.  But it is still probably too little too late, however noble it may have been:  The country borrowed too much and it can’t grow fast enough to pay it off.  So, yes, Virginia, there will be a debt restructuring.  The best line of evidence come from the Greeks themselves, who appear to be mounting a stealth bank run along with capital flight.  The FT informs us that sales of gold coins are now running at a 5:1 ratio relative to bouillon even as more bank deposits are transferred abroad.  Put it this way, if the total amount of bank deposits transferred abroad in 2011 matches 2010, private capital flight will undo completely the amount European policymakers hope private creditors will roll over under some sort of Vienna Initiative Plus standard.

On the Vienna Initiative Part Deux, private sector participation will probably be mixed and underwhelm official hopes, leaving the bottom line, essential question:  How much money is Germany and the rest of Northern Europe willing to kick in to bail out Greece, Ireland and Portugal?  Watch tomorrow’s EU Summit for some hints on this.

Heretofore we have practiced only tactical shorting (like our sell EUR recommendation) when it came to the Greek/EU sovereign debt crisis Part II, but the events of the past week has nudged us decisively toward establishing some more or less permanent shorts until the Greek goats come home.  Here are four asset types to think about:

1. Because it’ll likely be only French and German banks that will be successfully coerced (under threat of greater regulatory scrutiny) to “voluntarily” roll over Greek debt in the name of Vienna – a process that will very likely mean marked-to-market present value losses – after the relief rallies of the past week we are far more inclined to establish shorts on French and German banks highly exposed to Greece.  We are looking for good levels to short GLE:FP.

2. We would buy EURIBOR futures to the end of 2011 on a view that the messiness of looking after the sovereign debt crisis will constrain future ECB rate hikes far more than is priced nor appreciated by markets now.

3. While we liked buying the Spanish banks during the recent, short relief rally, we now switch 180 degrees and are also looking for appropriate levels to short BBVA:SM.  The question of whether Vienna Initiative Plus also (likely) equates to a selective default will probably put more pressures on Spanish bank funding and hurt their stocks.

4. Finally we think the euro has to get much weaker during this debt workout.  We’ve returned to thinking about 1.18 levels for the unified currency, the level at which it entered the world, at a 1-year time horizon via way out-of-the-money puts.

The risk to our views is the degree of comfort that equity markets are showing about, ho hum, yet another Greek Rescue.  We, on the other hand, a’re basically saying the jig is up.

Two Days Hence

Trading today should be done with a view that risk markets are probably underplaying the outcome of the FOMC.  While this is a two-day meeting to prep the committee for guidance it’ll give in six weeks when QE2 is well and truly over, we nonetheless expect some guidance now in the Bernanke presser, which could roil markets that are now happily assuming the Fed will just be loose forever.  Nothing lasts forever.

Otherwise, tomorrow’s data, we think, should show greater than anticipated slowdowns in the EU flash PMIs, if how we read yesterday’s ZEW for Germany and Europe was correct.   Focus will also be on HSBC’s flash manufacturing PMI for China, to see if the slowdown continues.

Begin today by acknowledging that overnight our lowered NZD/JPY stop of 65.9340 was hit.  Even inclusive of paying away a carry, there should be a small profit on this trade entered at 66 the figure a few days ago.

NZD/JPY is again lower but a stop is a stop.  We’d been setting very tight stops in what appears to be choppy and bidirectional markets.  Nonetheless it’s not good that 2/3 of our most recent trade recommendations have been stopped out, even if we made money in the aggregate.  The lesson here (and here we give ourselves a good hard kick because we’ve made this mistake before) is not to ignore our own rule and get out when asset prices move in our direction but for the wrong reasons (see our previous note).

As we have said all this week, we are looking for a relief rally after news on Greece gets about as dire as it can.  We’re not too far away, with news the next round of Greek solutions could be delayed till July.  But if July then what will European leaders have to discuss at their 23-24 June Summit – they might as well cancel that, too.  For fear of the massive downdraft this would then create for Europe’s hospitality and travel industries, we still think they find some way to declare victory, beginning with the Merkel-Sarkozy meeting Friday.

[US President Obama, during Merkel's US visit, urged Germany to get out in front and lead in its sovereign debt crisis resolution.  The irony of all this is the German push for debt restructuring is precisely Merkel attempting to lead!]

While we haven’t executed, assets we might want to own when relief does come include the big Spanish banks, on the view that further contagion is off for now.  Maybe a US industrial production number expected by consensus to rise 0.3% when reported today will help the cause.

Austraaayaaaah - highlights of RBA head Stevens’ speech today:  If inflation data strong late July, we’ll hike.  So that should set us off for another month of merriment guessing what’s on Glenn’s mind.  Of course some smart bloke might actually bother to fine-tune an inflation forecast here or there, but why spoil the fun?  The only folks who change their minds more about hike/no hike, inflation/no inflation than Australian economists is my wife, with furniture.

We did find it strange, however, to see AUD rallying on the idea China’s slowing is not so bad, when the head of Glencore – one guy who should really know – said point blank Chinese commodity demand is slowing.

China - an earnest Globe and Mail article summarized recent labor unrest in Guangdong.  An unmentioned cause of such unrest – low-skilled jobs are leaving Guangdong.

Philippines - Moody’s upgraded the country to Ba2, catching up with S&P and Fitch.  We’re within a couple of years when all of the ASEAN-4 will be investment grade (knock on wood something bloody doesn’t happen after the Thai vote).

Finally, can’t resist – some Quotes of the Day:

1) From an FT editorial:  “… the reality is that EU governments are fast on their way to holding all Greece’s debt.”

2) From the Chief Operating Officer of the Japanese clothing purveyor Fast Retailing:  “Wearing our clothes actually keeps you cooler than when you’re naked.”  No confirmation of unverifiable reports that Anthony Weiner, deep in rehab, bought himself a set.  By the way, the way the Japanese are pitching in (as they always do) to conserve energy this Summer will, in our estimation, have impacts way beyond 2011.

Today, however, is more likely risk-off as confirmation of slower Chinese growth plus another rate hike in prospect for either June or July will contribute to concerns over global growth, ahead of US retail sales that the surveyed Bloomberg consensus expects to shrink a half-percent.

We maintain one risk-off trade recommendation and that has been to sell NZD/JPY.  Here, however, we note one of the worse outcomes to hit a strategist:  To be right, but for the wrong reasons.  NZD reversed its record-breaking run towards strength yesterday on distressing news of large aftershocks hitting Christchurch, one of which has now been graded as strong as the original February 2011 quake.  Our hearts go out to residents, who have demonstrated a determined amount of resilience.

When we’re right for wrong reasons, we are tempted to take off the trade immediately.  But because there is always the possibility European policymakers shoot themselves in the foot one last time, we will keep this paper position open at least one more day:  Entered at 66 the figure, indicating at 65.3414; target 63.40.  We are, however, again dragging down the trailing stop to 65.934 from 66.66.

The kiwi has benefited in recent weeks from market talk that China would add kiwi bonds to its holdings.  Certainly the prospect of the world’s largest foreign reserve holdings adding to its New Zealand investments in what is a small fixed inome and FX market is enough by itself to be material for the kiwi.  We, however, are probably less excited by this news than markets, for the following reasons:

• China already holds kiwi bonds;
• It is likely to want to add, but not in large size.  The problem with all Asia-Pacific fixed-income markets outside of Japan is that the aggregate amount of assets on offer remains too small to be attractive even to the likes of some of the region’s lesser reserve hoardings, much less to an institution like SAFE; and,
• It would not be difficult for an institution like SAFE in a small market like New Zealand’s to “corner” the kiwi but that would hardly be neighborly; nor, in our view, consistent with the long-range investment goals of China.