The Yen, Gold and a Losing Hedge Fund in London
"...Gold investors often think they'll make big money when other asset prices collapse. But that might not prove true in the short term..."
WHATEVER happened to risk? "Investors bet everything would go their way in 2006 - and their gamble was absolutely correct," says Ross Moore, director of research for Colliers International.
Moore was referring to US commercial real estate, but his sentiment holds true wherever we look. This week the MSCI index of global stock prices hit a fresh all-time high. The Nikkei in Tokyo closed at a 10-month high. Shares traded in London jumped more than 1.4% from last Friday.
Long-term bond prices have also risen this week after the US Fed chose to keep Dollar interest rates on hold. Oil's creeping back towards $60 meanwhile, and even gold has been shooting higher. That lump of yellow metal - supposed to offer "negative correlation" with other asset classes - had gained 8.4% since the start of January before suddenly selling off as New York opened for business on Friday.
But more on that in a moment. For now, everything's up...everything except risk.
The VIX index of US stock market volatility is bobbling gently around its all-time record lows. It spiked up sharply last May...when all asset markets fell out of bed during the same torrid fortnight. But volatility - the "degree of unpredictable change" in asset prices, according to Wikipedia...the "spread of all likely outcomes" in the words of a 2005 textbook on the matter - soon slipped back beneath its silken sheets, and drifted off into a coma.
Volatility's deathlike slumber got started more than two decades ago. Since 1980, the annual volatility of UK and US equity prices has shrunk from 15% to barely 7% according to research by the Bank of England. Government bond prices have spurned risk faster still. Volatility in US Treasuries, UK gilts and Japanese government bonds has shrunk by more than two-thirds since 1981.
Corporate bonds have enjoyed a powerful decline in volatility, too. Earlier this month, the risk of owning European corporate bonds dropped to a record low according to the price of insurance charged in the City and Frankfurt. The price of buying a "credit-default swap" - effectively an insurance policy against bond issuers defaulting on their debts - has never been lower. Alongside volatility, in fact, CDS prices are the only thing not going up.
"The amount of debt used to finance European buyouts rose to 8.7 times earnings in the third quarter [of 2006] - the most ever," reports Bloomberg. "Real estate's time in the sun looks sure to continue for at least another 12 months," adds Moore. So investors in stocks, bonds and commodities are all slathering Factor 50 sun cream on to each other's shoulders. See you on the beach!
If today's world of financial assets was already "priced for perfection" however - as Larry Summers, former Treasury Secretary to Bill Clinton, warned a meeting in Davos, Switzerland last week - then perfection just keeps becoming more flawless. Not a blemish or broken vein can be allowed to mar its beauty.
But what's this?
"Volatility on options for the Yen versus the Dollar [has] surged to a four-month high," reports Liz Capo McCormick for Bloomberg, "as traders bought protection against the risk that Group of Seven nations meeting next week will seek to halt the Japanese currency's decline."
You may already know the trouble a chill wind from the East could cause. The "Yen carry trade" may be worth between $35 billion and $1 trillion on some guess-timates. When it starts to unwind, everything currently propped up by cheap Yen could tip into a tailspin.
Why so? Japan began slashing Yen interest rates towards zero at the start of the '90s in a failed bid to stop Tokyo's stock market and real estate bubbles from imploding. Investment banks and hedge funds the world over took all they could get...borrowing Yen at near-zero cost and selling it on the currency markets. They then put the cash - cost free between 1998 and 2006 thanks to Japan's zero interest rate policy - into better paying investments including US bonds, UK cash deposits, and emerging market equities.
Should the Yen now start rising, just as global equities, commodities and bond prices are touching record highs, this "zero cost" money machine could suddenly become very expensive. Witness what happened to LTCM in 1998.
The Yen had nearly halved in value versus the US Dollar between 1995 and 1998. Amid the fallout from the Asian Crisis and Russian debt default, a small news release stating that the Japanese government would start reforming the country's banking sector created a spike in the Yen. That spike led in part to the infamous blow-up of Long Term Capital Management, a hedge fund that had pushed its way to the front of the Yen carry trade buffet and gorged itself on cheap sushi.
Fast forward to Feb. 2007, and so far this year the Yen has continued to sink under the weight of record-low interest rates. That's only made the Yen carry trade more attractive, of course. "Queues show no sign of dwindling at Japan's ATM," said a headline in the Financial Times this week. But on Monday next week, leaders from the G7 group of industrial nations will meet in Essen, Germany.
Top of the agenda, what to do about the Japanese Yen.
"Exchange rates will be discussed and that would include discussion of the Euro-Yen exchange rate," said one EU policy wonk on Tuesday. He's going to chair next week's G7 meeting, and the Yen promptly rose off its record lows of ¥158 per Euro.
US and Eurozone export companies want the Yen to rise further. The world's hedge funds and investment banks, however, must be praying that it won't. Either way, sharp-minded currency traders are likely to win out if volatility suddenly returns to the forex markets. Annualised volatility in the Dollar, Yen, Euro and Sterling peaked in the late '80s. It's since pulled back from 12% to less than 8%.
Volatility's not dead, of course, only sleeping - and we shouldn't mistake volatility's deep slumber for a terminal coma. Stock markets and bonds are priced for perfection, remember. The lack of fear in all financial markets has also encouraged many exuberant players to gamble on asset classes they don't understand.
Witness the sudden drop in everything last May. Gold, copper, US stocks, emerging markets...Sharp drops in one market spilled over into other asset classes as investment funds tried to cover their losses. And maybe that's what we saw Friday this week in the gold market.
"Red Kite Management Ltd's $1 billion metals-trading hedge fund, a highflier that racked up gains last year, has suffered losses so far in 2007," reported Gregory Zuckerman and Alistair Barr in the Wall Street Journal on Friday morning.
"Now Red Kite is asking its investors to give it more notice before they withdraw from the fund. As of Jan. 24, the London-based firm was down about 20% for the year, according to an unofficial estimate that the fund provided to one investor. It was Red Kite's worst one-month performance in at least a year, according to an investor who has seen the firm's results."
Red Kite posted gains above 100% for 2006 according to a separate report in the WSJ. One of its funds - Red Kite Metals LLC - racked up 190% gains. Now the market's stopped going their way, and their gambling has suddenly gone wrong. On Wednesday Red Kite wrote to its investors asking for permission to extend their withdrawal notice period from 15 days to 45 days.
"Hedge funds sometimes extend redemption-notice periods if they're expecting large investor withdrawals," explain the WSJ reporters. "By getting more advanced notice, funds have more time to sell positions and return investors' money in an orderly fashion."
A pullback in gold was to be expected, of course. The metal had shot more than 8% higher for the week in the hour before New York opened on Friday. But what if Red Kite were holding large gold positions alongside its more famous bets on the direction of copper? Might that explain the "wave after wave of sell orders" that one gold dealer reported to Bloomberg on Friday?
And if not Red Kite, then what about other heavily-geared hedge funds and commodity traders? Might they not see the recent spurt in gold prices as an opportunity to cover losses elsewhere...?
"The number of these lightly regulated investment pools that trade commodities futures has zoomed to more than 100 from 60 or so a year ago, says David Mooney, who runs a fund of commodity hedge funds for United Kingdom-based New Finance Capital," according to the WSJ article. "Assets of the 100 funds he tracks have grown to $24 billion from $14 billion, both from profits and new investor money, he estimates...
"In the same year, though, bad energy bets have led to closures of Amaranth Advisors, MotherRock LP and Ritchie Capital Management LLC's Ritchie Energy fund."
Gold investors often think a sharp sell-off in all other asset classes is guaranteed to deliver them big gains. But the "systemic risk" between Yen carry trades, US bonds, Sterling cash deposits, emerging markets and complex derivative trades is likely to scorch us too when it ignites - at least in the short term.
It will be a necessary risk in the short-term, in fact, as gold gains new investors during its long-term climb upwards.