Charles Gave sits in the hot chair this week and discusses a range of current topics in the twilight zone between politics, economics and markets.
In the beginning of the year, your message to clients was essentially that 2004 would not be a continuation of 2003, which everybody thought at the time. You saw a breakdown of the circle of manipulation, including the artificially low US bond yields, and that the record-low volatility in equity markets would bounce back up again, meaning tougher times ahead for the financial markets in general.
Being right so far, I must start by asking: "Are we done now with the market shake-out that we have had during the last couple of months?"
CG (Charles Gave): To answer that question we have to recapitulate where it came from: In 2003 we experienced the Mother of all carry-trades. Everybody and his brother borrowed US dollars. I mean it was a "no-brainer". Everybody "knew" that the dollar had to fall, mainly because of the twin deficits [the US budget deficit and the US current account deficit - ed.]. On top of that it was a steal to borrow at 1 percent. As a result there was a huge short position built up in the USD last year.
What happened to all those dollars, then?
CG: It went into anything and everything. From US Treasuries to Chinese shares and FDIs. From commodities to real estate. From Australian dollars to euros. And one of the amazing things about that is that asset managers who had these assets in their portfolios believed that they had a well diversified portfolio, when looking at historical correlations between these asset classes. But guess what happens when the short dollar positions now are being reversed? Suddenly all these correlations run sky high and the portfolio does not look as well-diversified any longer.
So what you are saying is that the unwinding of the short dollar positions has begun?
CG: Yes, it has. With the Fed slowly but surely increasing its sabre rattling and the Chinese authorities trying all they can to curb lending - we must remember that for all intents and purposes China is in the US dollar zone - the liquidity situation is definitely tightening. This also showed by our Velocity indicator, which started to head South decisively in March and has only slightly recovered by now. But the unwinding of the short dollar positions is only half of the story. For the US we also have the artificially low bond yields that we have been describing as a part of the "Circle of manipulation".
CG: It started with us asking ourselves how anybody in their right mind could buy Treasury Bonds, a nominal asset, yielding 3.5-4 percent when real growth was accelerating to 4-5 percent and the Fed acted as if it had forgot all about a phenomenon called inflation. The first buyers we found were foreign, mostly Asian, central banks. Of course, not only were they at the other end of the US current account deficit, having to buy all the dollars that their domestic exporters brought home for exchange. On top of that they had to supply local currency against dollars for all the foreign investors wanting to participate in all the business opportunities in their home countries, i.e. everything from Beijing apartments to car factories or simply equities. This means that these central banks ended up with huge bags of dollars which in turn they bought US Treasuries and agency papers for.
And the second category of buyers…?
CG: …Were the hedgers downstream of Fannie Mae. Let me explain: When a home-owner takes out a mortgage with Fannie Mae - let's say for 20 years at 8 percent - Fannie Mae turns around and issues bonds of equivalent duration. Thanks to its good credit rating this refinancing can be done cheaper, let's say at 7 percent, meaning that Fannie Mae makes a handsome little margin of 1 percent. However, the US legislation gives our home-owner the option to repay the mortgage in advance and take out a new one, so if yields falls he will be inclined to do so, which we see in the refinancing statistics. This of course presents a risk to Fannie Mae, since if yields fall 200 b.p. for instance, Fannie Mae will see its profit turn to a loss.
So what does Fannie Mae do?
CG: It turns to a bank to buy insurance. Goldman Sachs for instance could guarantee to cover Fannie Mae for any losses from a fall in yields, at a cost of, let's say, 50 b.p. This effectively means that the risk is moved from Fannie Mae's balance sheet to Goldman Sachs's.
And how does Goldman handle that risk then?
CG: It buys Treasuries against it. But typically they only cover part of their outstanding position, maybe 40 percent. If yields go up, they make a killing, if yields go down, they quickly cover their remaining position. Any small losses on the way down are amply covered by the insurance premium. The interesting part, though, is that if yields start to fall, they have to buy, thereby making yields fall further, and so we have our downward spiral on yields which has been in effect for so long. What is more is that they borrow at 1 percent to invest in these Treasuries that yield 4, so they make money like bandits on the carry-trade as well.
I see. So here we have two "forced" buyers of bonds in the system. But how and where does it end?
CG: When the ferocious appetite for Treasuries is no longer enough to push yields further down, for instance if growth spurts too far or the Fed goes from a relaxed mode to a tightening mode, there is a clear risk that yields snap back. This would be a night-mare scenario since it would mean a tumultuous unwinding and big players in the financial system taking big hits on the chin. You know it is a sort of prisoners' dilemma; one or two players may close their positions profitably, but not all of them; that would lead to a panic. This is why the Fed, which is very well aware of the situation, is doing all that it can to make the unwinding go v e r y slowly, guiding the market along with distinct but gentle guidance. Yields will probably have to go to some 5.5 percent, or 3 percent real, to start attracting 'natural' buyers like pension funds, life insurers, etc.
Why does it have to go slowly?
CG: You know, as long as the loss of capital on the bonds from the rising yields is compensated by the profits on the carry-trade, the situation is sustainable. But anyway, the period when the financial intermediaries made money like bandits is over. Interestingly, it seems as if the market has already taken notice of this, since the S&P500 Financials index has not only turned down, but actually shed more than the S&P500 Composite on presentations of very good first quarter earnings.
So I go back to my opening question: "Are we done yet?" Or are we still in 'Bear Forest'?
CG: If we start with the bond market, we don't seem to be 'out of the woods' just yet. According to our sources on bond dealers' desks, it seems as if we don't have a calamity before July-August, there will not be any. By then the unwinding will have come far enough and the terms would be bearable, thereby evading a crisis reaction. This also means that the Fed will have free hands to increase rates during the coming fall, despite the Presidential elections. We actually don't think that the elections will stop the Fed from doing what it has to do. It has not refrained from doing so historically. And anyway, if it doesn't raise when needed, it will be accused of helping Mr Bush, and if it does raise it will be accused of helping Mr Kerry.
And the conclusions on the short dollar positions?
CG: According to our calculations on the short US dollar position, there is more to do. And here we see a risk for the hedge fund industry, which is known for operating with high leverages, often in several layers on top of each other. Here, a reduction in the US current account deficit - which effectively pushes US dollars out of the US - could hurt really bad! So all those who cry for a reduced deficit should really be careful with what they are wishing for.
So, all in all, we can still have a shaky period ahead of us before markets start to stabilize?
CG: Yes, that is our scenario. We believe that we are in an adjustment phase which still has some way to go. After that markets will hopefully start looking at fundamentals again which should make them a little easier to interpret.
Charles Gave has been researching tactical asset allocation for more than thirty years. After three years as a financial analyst in a French investment bank, Charles created in 1974 a research firm called Cecogest, an independent research firm with a large global client base. In 1986, Charles stepped away from pure research to move into money management. He co-founded Cursitor-Eaton Asset Management where he was Chief Investment Officer. At Cursitor, Charles managed over USD 10bn of institutional money on a global asset allocation mandate. Cursitor was sold in 1995 to Alliance Capital and Charles remained with Alliance Capital until 1999. At this time, he elected to go back to his first love: research on tactical asset allocation. He left Alliance Capital to create GaveKal Research, GaveKal Capital & GaveKal Securities. Charles sits on the board of several European companies, including Global Fund Analysis and Ecowin.
Reprinted with permission from GaveKal Notebooks, a subsidiary of GaveKal Research, which provides advice and out-of-consensus investment ideas in the field of global tactical asset and currency allocation based on the study of economies and financial markets. Readers can find them at www.gavekal-notebooks.com  <http://www.gavekal-notebooks.com/ >