Friday, May 13, 2005

Forex Update - Market Commentary


Economist and traders continue to be confused by the conflicting data. On the one hand there appears to be a "flight to quality". Hedge funds have apparently been caught holding very low quality, risky and inadequately hedged paper. The trades are being "unwound". Who knows if there is going to be a hedge fund blow up?

Jim Cramer explained the GM hedge fund problem a few nights ago. He said traders had purchased GM preferred stock and sold the GM common short. The prevailing thought that GM would have to cut its common dividend but of course continue to pay the preferred. The common would sink in price but the dividend would hold up the preferred. When Kevorkian tendered for the common, he crushed these leveraged trades big time. A day or so latter, GM announced that they would pay the common dividend. The short sellers lost on the short side on a highly leveraged trade.

The biggest unwinding appears to be in the bond market. This perhaps explains the unusually low spreads we were seeing in recent months. Apparently, hedge funds were speculating that long treasury rates had to go up in a strong economy. They further speculated that credit ratings would improve on junk bonds in a strong economy. Thus they purchased junk bonds and sold treasuries short. Now they are in a squeeze and are being forced to cover their shorts at whatever price. The ten year bond has been in rally mode as has the US dollar. There are lots of cross currents here.

The above conjecture about hedge funds being long junk and short treasuries is consistent with the inconsistency of the economic numbers and market action. Retail sales were out the roof, jobs were out the roof and it looks as if GNP will be revised upward for the first quarter. The economy did not grow at 3.1% net but perhaps as fast as 3.7% net. How else can one account for corporate profits coming in at 14% growth versus projections of 7%? It makes a lot of sense that the economy is stronger than is perceived, that commodity speculation pushed prices too high, that productivity continues to hold