Deleveraging continues - Part 1
Since we expect to comment quite abit about this trend, we thought it wise to number our posts on this subject. Thus, here is part 1…
Deleveraging, or the gradual disappearance of liquidity in financial markets, can take several forms. Here are two of those forms:
1 - The unwinding of the ‘carry trade’, the most popular of which is long higher yielding government bond/short lower yielding government bond. The typical ‘carry trade’ format might be long US Treasuries/short Japanese Government Bonds. It produces a ’spread of 300-400 basis points for the investor (hedge funds or even Japanese consumers) without the nasty regulatory requirements of reserves, capital, financial reporting and all of those other hurdles to unfettered risk. However even hedge funds must manage risk, and an unwinding of the ‘carry trade’ can mean a reduction in overall fund risk (remember, this trade is usually executed with miniscule margin). If hedge funds are unwinding risk in the ‘carry trade’, they are probably doing the same elsewhere. And, what is a prototypical ‘risky asset’? The S&P 500 can be used as that ‘risky asset’ in getting our arms around the question of current hedgie risk stance.
In other words, as the carry trade gets unwound, Yen bonds are bought back, strengthening that currency. If hedgies are taking risk off the table, one would expect the SP500 to fall as the Yen strengthens.
Until the events of Feb 27 (the possible beginning of delevering), the correlation between the Yen/Dollar exchange rate and the SP500 was practically zero. However, since that fateful day, the correlation has been approximately +0.70 (on a scale of -1 to +1). Of course, over the last two weeks of that period, the correlation has been closer to +0.20. However, the conclusion can be that we are in a deleveraging trend as indicated by the relationship of the carry trade to the US equity values.
2 - The Return of the Regulators. Take a look at this from Chris Whalen’s newsletter, Institutional Risk Analytics (http://us1.institutionalriskanalytics.com/pub/IRAMain.asp) - recommended reading for those interested in the view from the banking sector:
"For over a year, we have been getting reports from former auditors and federal bank regulators about quiet appeals emanating from Washington asking them to come out of retirement. Why lure a retired bank examiner with 25 years bank audit experience back into service? To consult for small and medium size institutions facing internal controls problems. One case involved a community bank newly involved in C&I lending. Another involves a regional bank with a case of toxic derivatives poisoning. But all of these triage samples involved one common malady: financial innovation.
More recently, subscribers to www.fbo.gov have witnessed a flurry of proposals to enhance the flow of data and other resources available to federal bank examiners. In at least one case in 2007, a request for proposal came out of the Treasury that was intentionally structured to attract former regulators in a consulting capacity to act as advisors to their former colleagues. The new regulatory advisories regarding exotic mortgages, etc., fall into this category as well."
The banking regulators are starting to sweat bullets over subprime mortgages and other similar ‘innovations’…a true contradiction to Chairman Bernanke’s "What Me Worry?" stance. Subprime mortgages and repricing ARMs will indeed have an impact on residential real estate values over the next two to three years…and the result must be further deleveraging in the US economy.
