OT: Possible Hedge Fund Default

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Found on the Bear's Forum at prudentbear.com:

( BRIDGE NEWS ) New York, Jan 28 - A dramatic flattening of the U.S. yield curve this week and huge sudden moves in some foreign exchange markets have spurred renewed fears of potential hedge fund defaults. The sharp moves also have stirred some debate on whether the Federal Reserve will be called on to look more closely at the yield curve situation. But most sources said it was unlikely the Fed would entertain any action, and some were adamant that Fed intervention was unneeded.

Meanwhile, several commodity-based currencies were under fire, with the Australian dollar on target for the largest 1-day loss in more than 3 years and the largest 1-week slide since 1990.

The rumor mill was rampant this morning that one or more hedge funds based on the West Coast were unloading losing trades in both U.S. credit markets and the Australian dollar.

One trader close to the action refused to talk on the record about any specific firms, but said several hedge funds were getting "murdered" on spread trades between 30-year bonds against 10- and 5-year notes. These spreads are known in the trading community as NOB (10-year note/bond) and FOB (5-year note/bond) spreads.

Given the massive slide in the yield curve in recent days, it's no surprise that several funds have been pinched into an uncomfortable equity standing.

SWIFT MARKET CHANGES, AND CALLS FOR THE FED In fact, there were calls from some quarters for the Fed to step in and take action to stem the dramatic flattening of the yield curve. However, other traders said it was out of line to expect the Fed to intervene in the current environment.

For perspective, consider this: The spread in the credit futures market between the bonds and 10-year notes has soared 96 basis points in just eight sessions. At $1,000 per 32 basis points and given open interest in both products of more than 500,000 contracts, you're talking about a potential equity swing in just the futures market of $1.5 billion.

Multiply that several times to account for cash and other derivatives trades linked to the yield curve, and you have an idea what kind of investment money is at stake.

"It's not so unheard of that this would happen...but for it to happen this fast is a shock," one hedge fund manager said. "This all happened over six days; no one had a chance to get anything on." One trader said the Fed should take advantage of the wide spread to buy 10-year notes and sell bonds. He said this would have the advantage of looking like a normal market function linked to the spreads and not just as a specific favor geared to bail out hedge funds. "I think that's a crazy thought to say the Fed would try to stem yield curve inversion at this stage," said Dan Busiel, vice president of exchange traded instruments with Banc One. "Are some people getting in trouble because of this? Sure. But the inversion has been orderly and it's not as if we haven't seen an inverted yield curve before."

However, one New York-based hedge fund manager said that if the trend continued, there was a chance the Fed would step in to stem the tide.

"Basically what you're looking at here if it continues is that this could be Long-Term Capital times a thousand," the hedge fund manager said. "I mean, how many people do interest rate swaps? Thousands."

In addition, he said, these renewed worries could put a damper on the Fed's tightening policy. Most market participants expect the Fed to tighten the federal funds target 25 basis points at next week's policy meeting, but there were thoughts from some isolated corners that the sudden swing in credit spreads could put the Fed back on hold.

"The problem with this is that you're basically dealing with a Fed that was going to raise rates but now might not be able to because if they raise rates it's just going to cause deeper losses for these people," the manager said. "They've got to keep pumping in liquidity."

However, Gary Flagler, a colleague of Busiel's at Banc One, also was convinced that there was no need for the Fed to step in or alter any of its perceptions on interest rate policy.

"I don't think we're anywhere near that stage," Flagler said. "I consider this a 1-or 2-day phenomenon and 99 1/2 percent of America could care less at this point about the yield curve. Is there really any systemic risk right now? I don't see it." In addition, other well-placed sources in the market told Bridge it was highly unlikely the Fed would step into the market immediately to stem the tide using any type of market intervention. ( Hogwash! )

One source who spoke on condition of anonymity said the Fed did not view its role as restoring soured market positions by participants on an intraday basis. If participants have lost money on highly leveraged positions, it would be unlikely the Fed would buy Treasuries to restore market calm. ( No, they'll purchase agency notes and mortgage-backeds. MM ) The possibility that the Fed will adjust any interest rate increase it already was considering is a low risk probably at this stage, another source said.

Although most of the potential default fears were focused on the credit market, it was difficult not to notice the major moves under way Friday in the Australian dollar and other commodity-linked currencies.

"Although it's a rumor (hedge fund spurred selling in FX markets), I think it's worth something; this is obviously stop-loss related," said Tomoko Iwakawa, vice president and foreign exchange adviser with Union Bank of California. "For both the Canada, Aussie and Kiwi to move this much in 1 day is huge. This is strange movement."

End



-- Susie (Susie0884@aol.com), January 31, 2000

Answers

Link

-- Susie (Susie0884@aol.com), January 31, 2000.

Yep, this is definitely potentially On Topic!

Yet another thing to worry about...the markets still do not seem terribly stable.

-- Mad Monk (madmonk@hawaiian.net), January 31, 2000.


To say the markets appear "unstable" is the understatement of 2000. The PPT, Fed and Treasury, are juggling a lot of balls right now. Currency, gold, oil, bonds, "economic expansion", and a host of others.

"They've got to keep pumping in liquidity." This is the thing to watch.

-- Dave (champeaudavid@yahoo.com), January 31, 2000.


Susie,
Great Find! Thanks for the link.


-- Possible Impact (posim@hotmail.com), January 31, 2000.

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