Commodity Bubble Bursts

For the past 8 months there's been one big trade that has made money more or less every day. It's entailed being short global stock markets, especially financials, short credit (bet on widening CDS spreads), long commodities, long commodity-related stocks, short the dollar, and bet on a steepening yield curve (falling 2-year yields relative to 10-year/30-year yields). This week all of that reversed, which was good news for Johnny Mutual Fund but terrible news for Jimmy Hedge Fund.
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Hedge funds suffered because since this has been the only trade working, a lot of them were playing it, and levering it up in a big way. As people took down exposure this week these trades unwound, which reversed all of the trends that had been working for 8 months.
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We don't know if the Bear Stearns blowup was the catalyst, but looking back whe should have seen the whole thing coming. As discussed last week, "If one more house follows the path of BSC, or even if people are afraid of it, this CDS market failure has a strong probability of occurring. If this happens people will be forced to take down exposure or re-hedge in markets that are still functioning, namely stocks, commodities, and bonds."
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The Fed managed to create more or less a soft landing for the system this week, at least temporarily and with a raw deal for BSC shareholders, and the lack of a systemic failure but dramatically low price for BSC shareholders initially tightened CDS spreads and hurt stocks.
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Economic data for the week was generally negative, which disappointing data on New York and Philadelphia manufacturing, jobless claims, and building permits. And the Fed cut 75bps, which was less than the 100bps hedge funds and other fast money traders expected.
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Put it all together -- the end of the world not occurring on Monday, weak economic data, a better than expected outcome for the dollar (smaller rate cut), plus more forced unwinds out of hedge funds -- and this week was the result.
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Still, it's hard to give a real "fundamental economic" explanation for everything that happened -- how to explain the S&P rising 3.2%, transports rising 4.5%, financials rising 12%, yet emerging-market ETFs like EEM and FXI down 1-2%? Railroads, which benefit from rising demand for energy and materials, rose 2.6% while commodities and commodity-related stocks got crushed.
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Credit spreads tightened dramatically, and the 2-year rate rose 12bps, yet 10 and 30-year treasury rates fell sharply and the 3-month T-bill rate fell the most of all, a whopping 60bps down to 0.57%. Treasury bills maturing next week yield a scant 0.10%. Short-term treasuries now yield less than their Japanese counterparts, which is unbelievable and a sign of extreme risk aversion, yet financials and transports acted as if an economic recovery is on the way. Of course, in addition to Bear Stearns going out of business a couple other big financial companies, NCC and CIT, entered the land of extreme distress, and the ratings agencies either downgraded or put on negative watch the credit ratings of Goldman Sachs and Lehman Brothers. Simply put, there's no good "real economy" way to explain what happened.
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Instead, here's a great explanation by James Aitken of UBS:

It's all about "phone call flow". If the over-geared short gets the call from his broker telling him his haircut has gone up and his leverage has gone down, the market goes up. If the over-geared long gets the call, the market goes down. If they both get the call at the same time, then you have historic price action. If the phone call comes from the central bank, which inevitably it will, and on an unprecedented scale, then the market goes wherever they say it should. Do not lose sight of the fact that whatever we think about moral hazard, the way out of this for global central banks is by reigniting or reinflating the ponzi scheme. In the meantime, try to avoid answering the phone, because as golfer Fred Couples once memorably said, there might be someone on the other end.

The scale of the leverage - which so many people mistook for liquidity – which built up in the system over the past few years dwarfs any previous crisis. While the spread between the price a long-term investor would buy a distressed asset on what the unleveraged return profile on that asset looks like and the price at which ridiculously leveraged investors continue to own that same asset is narrowing, it is far from closed. My advice to long-term, unleveraged pools of capital remains unchanged: don't just do something, sit there.

The global economy of 2007-2008 prseents a case study hundreds of years from now as an example of the dangers of too much leverage and speculation. Taking its cue from the US economy, the global economy financial markets became more important than real economic activity for global growth. And what's impacting financial markets now is not real economic data, but the structural mechanics of those firms and individuals who took on more leverage and debt than they could handle.

Unfortunately, since growth depends on what happens in financial markets, for the next few years anyway we'll be at the mercy of the balance sheets of Lehman Brothers and Merrill Lynch, of subprime homeowners, of levered hedge funds, of ratings agencies and of old and new acronyms like FHA, TAF, and TSLF. It's not what you'll see on CNBC or read in the Wall Street Journal or New York Times but that's the reality of our situation.

Good trading and great risk management to all.

Educational use only. Never intended as investment advice.