Wednesday, December 17, 2008

Will Volatility Collapse in 2009?


A late sell-off in financials dragged US shares lower as investors worry there are few quick fixes for either banks or the economy:

Also weighing on the financial space was disappointing financial results from Morgan Stanley, though a new credit agreement for retailer Macy's helped offset some of the market's weakness and drove consumer companies higher.

For financials, declines included big drops for Fifth Third, down 48 cents, or 6 per cent, to $7.51, and PNC Financial Services Group, down $3.22, or 6.5 per cent, to $45.98.

Many of the companies in the financial sector had rallied broadly yesterday in the wake of the Federal Reserve’s interest-rate decision, though such an unprecedented move was viewed by many on Wall Street today as an indication of just how dire the economic picture is.

And even though the move boosted certain areas of the credit markets, it will take months before the total force of the action filters its way onto banks' balance sheets and spurs lending.

In one sign of just how weak the current climate is for banks, Morgan Stanley reported a fiscal fourth-quarter net loss of $2.3 billion, or $2.34 a share, following yesterday's report of the first quarterly loss for rival Goldman Sachs Group since Goldman became a public company a decade ago.

Although analysts had expected Morgan Stanley to post a loss of 34c a share, the news sent Morgan Stanley up 37c, or 2.3 per cent to $US16.50.

"That the market was able to shrug off Morgan today and Goldman yesterday is important. Six months ago, that (news) would have taken every financial down 30 per cent," said Bill Groeneveld, head trader for vFinance Investments.

Still, Mr Groeneveld said it appears many clients are simply "walking away" from the market at the end of the year, with few signs that investors are willing to take the risk of equities over several safer asset classes.

Overall, the Dow Jones Industrial Average closed down 99.80 points, or 1.12 per cent, at 8824.34. The Standard & Poor's 500 index lost 8.76 points, or 0.96 per cent, to 904.42, and the technology-heavy Nasdaq Composite shed 10.58 points, or 0.67 per cent, to 1579.31.

Helping pare some of the losses was retail giant Macy's, up $1.54, or 18 per cent, to $10.01, after it secured amendments to covenants on its bank-credit agreement that the company said will give it substantial liquidity to weather the current economic downturn.

And even volatility pointed at a rosier picture today, with the CBOE Volatility Index, know as the “fear” gauge, dipping 4.8 per cent to 49.84, marking its first move below 50 since November 5.

The drop in volatility is important. If a slow but steady rally in equities continues, I would expect volatility to fall further in the coming weeks.

But it's not the equity markets that I am thinking about these days. According to Bloomberg, the dollar traded near a 13-year low versus the yen and at the weakest level against the euro since September as the Federal Reserve’s near-zero interest rate policy reduces the appeal of holding U.S. assets:

The greenback also slid to a two-month low against the Australian dollar as longer-term Treasury yields fell and U.S. stocks declined on speculation the Fed has few tools left to combat a recession. Investors including hedge funds reversed bets the dollar will appreciate to minimize losses as the end of the year approached, traders said.

“The next step is for the Fed to start buying Treasuries, which will depress yields further and lead the dollar lower,” said Hideki Amikura, deputy general manager of foreign exchange at Nomura Trust and Banking Co. Ltd., a unit of Japan’s largest brokerage. “The U.S. stock market shows few signs of life. I don’t think people are waiting to buy the dollar on the cheap.”

This afternoon, I was talking with a buddy of mine that trades currencies. He nailed this latest US dollar sell-off and was telling me that the greenback will weaken further until people start realizing that global interests are going to converge to zero, which is when you will see runs on other currencies.

We then talked about hedge funds deleveraging. He told me most hedge funds raised a lot of cash, waiting for redemptions at the end of the year. Once that happens, they will put the cash to work.

"There may be more redemptions at the end of Q1 2009, but after that, you would expect volatility to decline further".

We then had an interesting discussion on volatility. I told him that I agree with his call that global interest rates will converge to zero and that I expect interest rates to stay low for a very long time. The Fed will not consider raising rates as long as the risks of deflation are still present.

Other central banks will have little choice but to drop their rates too as they battle recession in their economies.

Importantly, in a word of zero interest rates and declining equity, currency and fixed income volatility, what will be the major trends going forward? Might we be entering a new stage of financial markets where volatility collapses in all major asset classes and stays low for a very, very long time?

I am asking this question to myself and thinking that if this is the case, global macros, CTAs, short-sellers and volatility arbitrage funds - all the hedge funds strategies that made money in 2008 - might be in for some problems in the second half of 2009 (if volatility collapses, there will be no major trend in these asset classes).

Most of the global macro hedge funds are not true global macros who can trade in all markets - equities, currencies and bonds. Most of them focus on bonds and/or currencies, but engage in little trading in equities.

Why is this important? Because if my thesis is correct and volatility simultaneously collapses in equities, bonds and currencies in the second half of 2009, it will be next to impossible to make money in tactical asset allocation next year.

Moreover, as the sources of alpha shrink, pension funds will find it increasingly difficult to reach their required rates of return.

According to Eurekahedge Pte. Ltd, the global hedge fund industry attracted an estimated $4.1 billion in new money from investors in November, even as performances dropped for a sixth straight month:

The inflow was swamped by $57.3 billion in redemptions, according to a report posted on the website of Singapore-based Eurekahedge. Distressed debt investment funds were the only strategy that attracted new money because of the attractive valuations in the credit and high-yield markets, the report said.

It expected trend-following and arbitrage strategies in the commodity and currency markets to be profitable in the near term, while opportunistic or value bets in the credit markets promised longer-term gains, said the independent data provider and research house in the report. Performance-based gains in assets were made in Japanese, Latin American funds, managed futures funds, which trade futures of stocks, bonds and commodities, and event-driven funds that invest in companies going through corporate actions such as takeovers and spinoffs, the report said.

Hedge funds lost $94.3 billion in November due to market declines, while gains totalling $76 billion were made in some funds. That pushed the decline in hedge funds for the month to $71.5 billion, Eurekahedge said, based on preliminary figures taken from 59.2% of the funds it surveyed as of 15 December.

Hedge funds fell 0.8% on average in November with 67% of the funds reporting, as measured by the Eurekahedge Hedge Fund Index, which tracks the performance of more than 2,000 funds that invest globally. The final figure for the month may be a 2% decline, said Eurekahedge, which typically receives data from poorer performing funds later. The sixth monthly drop is the longest ever losing streak based on Eurekahedge data.

The slump takes declines to about 13% this year as hedge funds accelerate job cuts and brace for the biggest annual losses and investor withdrawals since at least 2000, according to Eurekahedge data.

Distressed selling and the rollback of debt-funded investments continued to pull down funds as the credit crisis sent the US, Europe and Japan into the first simultaneous recession since World War II. The MSCI World Index slumped 6.7% last month. Hedge fund industry assets peaked at about $1.9 trillion in June, and have fallen about 20.5% to $1.55 trillion, Eurekahedge data show.

As hedge fund assets dwindle, volatility will eventually collapse in all markets. Moreover, in a new era of more regulation, less leverage, and shifting demographic trends, this could be an important structural change that will keep returns low in all markets.

But before volatility collapses, there is another big shoe which has yet to drop - commercial real estate. The National Association of Realtors said on Wednesday that the global credit crunch is putting a crimp on the U.S. commercial real estate market and the sector's decline will continue deep into next year:

Vacancy rates will likely increase in the office, retail and industrial sectors into the third quarter of next year, while vacancies among multi-family units are expected to remain flat, the trade group said.

"Although access to residential mortgages has improved, the opposite is true for commercial loans," said Lawrence Yun, NAR's chief economist. "We need liquidity for commercial mortgage-backed securities not only to free the market, but also to rollover existing debt," he said, encouraging U.S. policy-makers to step in to help.

The U.S. Federal Reserve and Treasury Department have vowed to soak up roughly a trillion dollars in mortgage-related assets to help restore the housing market to health and plan to commit billions more to support the consumer debt market.

In announcing a $200 billion the plan to free-up credit for consumer and small business lending late last month, the central bank said it might widen its aid and use the program to soak up fresh commercial loans that cannot find a buyer.

"Those additional steps are needed," Yun said in an interview with Reuters. "The commercial real estate market is frozen because there is no government backstop. Lenders are not making commercial loans because there are no private investors who want to hold them."

Under the existing program, the Treasury agreed to cover up to $20 billion in potential losses by drawing on a $700 billion financial rescue fund created by Congress.

By agreeing to take on the credit risk, the Treasury leveraged large-scale lending by the Fed. A senior Fed official told reporters on Tuesday the central bank could proceed along similar lines as it considers more ways to unclog credit markets.

The official said this was an area where the Fed could collaborate with the Treasury and the incoming team of President-elect Barack Obama, and that more guidance may be forthcoming in the future on what to expect.

A report last week from the Federal Reserve showed a contraction in commercial mortgage stock from June to August -- the first negative quarter in fourteen years.

"(That) data provided hard evidence of this drought in commercial real estate lending," Barclays Capital wrote in a research note on (day of week).

Cities like Detroit, Dallas and Phoenix are likely to see office vacancy rates top 20 percent in the coming months, the Realtors said, while average retail rent is likely to contract by 7.3 percent next year.

The Barclay's note says that multi-family housing should enjoy uncommonly healthy access to credit because mortgage-finance giants Fannie Mae and Freddie Mac iinvest in that space.

So expect the Fed and the Treasury to move in and backstop the commercial real estate market and then to backstop the consumer loan markets.

But it will be interesting to see how all these government interventions play out in the financial markets and the real economy. Will volatility collapse in 2009 and how will this impact market participants?

More importantly, will these government interventions help bolster pension funds? I doubt it and besides, the damage is already done.

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