Tuesday, February 27, 2007

Is "The Great Unwind" occurring now?

The authors of Dresdner Kleinwort's "The Great Unwind" appear to have hit the nail on the head in their warning of the eventual end game of the leveraged bets made by hedge funds.

As they put it in their report, as published in the FT: It looks like the process of building up leveraged spread bets has already run quite far. Risk premia in many markets are very low, making it increasingly difficult to find spread bets for new money. Market volatility has been driven to record lows (remember: selling a put is like shorting volatility). The process may not have much more room to run and may start to be more sensitive to factors that could threaten its delicate balance (such as a deterioration of corporate credit risk).”"The virtuous cycle on the slow way up (the supply and demand from building spread bets leads to tightening spreads, which in turn raises confidence to build new positions) turns into a vicious cycle on the fast way down.”So how vicious is this great unwind going to be? Well, the Dresdner pair estimate that investment banks sucked roughly $40-50bn in revenue out of hedge funds last year, mainly through sales/trading and services other than prime brokerage. That is about 15-20% of all industry revenues in investment banking.

Yet, while today's losses in global equity markets could be the start of a more general risk unwinding, it seems to me that we have seen false starts of this sort over the past decade. One sign I look for to signal "the great unwind" rather than what may in hindsight be seen as just a correction (albeit one which likely catches some of the more leveraged and least nimble funds off sides) is the reaction of the Central Banks. The now deeply ingrained habit of running to US Bonds for safety, which was evident today, suggests that the funds at least are betting that Central Banks will continue to support US Treasuries.

That is, to my mind, the difference between a correction and a real unwinding lies in the US bond market's reaction. So long as yields stay low and continue to drop on further equity market declines, this unwind will not be the great one.

Ultimately, it seems to me that the great unwind, when it does arrive, will lead prices in a direction which support a resolution of the international imbalances, most notably the US current account deficit. Thus, instead of cheaper commodities, commodity prices in $ terms will rise, and instead of lower yields for US Treasuries, US rates will rise.

In the event Central Bankers respond to today's equity market decline as they have over the past decade, by increasing liquidity, today may yet prove to be a watershed event in that the monetary authorities' ability to fight inflation will be seen to be quite limited. That change, if it comes to pass, should,
once the dust settles, make the mad scramble for real assets, particularly the precious metals, even more vigorous than it has been of late.