22 Jun 2007 “Hedge Hogs”
Once again the big unregulated hedge funds are roiling the markets. Stocks and bonds have been down over the last couple of days on concern that hedge fund losses at Bear Stearns may signal wider problems in credit markets, particularly the sub-prime mortgage markets. The two hedge funds’ speculation in sub-prime collateralized debt obligations has threatened collapse as creditors including Merrill Lynch, Bank of America, and Citigroup moved to sell some of their collateral at fire sale prices.
It is more than a little reminiscent of the Long Term Capital Management mess in the fall of 1998 when the world’s credit markets were brought to crisis by the eminent collapse of the giant hedge fund. The trigger wasRussia’s default on its loans. The Fed came in to rescue of LTCM then; Bear Stearns says it’s coming to the rescue of its two hedge funds today with $3.2 billion in loans.
Investors and experts alike worry that the sub-prime mortgage problem isn’t going away as fast as was earlier thought. “The problem is not what we see happening, but what we don’t see,” said Joseph Mason, associate professor of finance at Drexel University in Philadelphia and co-author of an 84-page study this year on the CDO market. “We don’t know the price of these assets. We don’t know which banks are exposed to this sector. These conditions are the classic conditions for financial crises across history.”
The problems at these and other hedge funds may be limited to themselves, but their actions to shore up positions might bleed into other credit markets, causing problems. That’s one of the factors driving long-term Treasury bond yields higher. Investors are selling longer maturities and snapping up short-term bills and notes, driving those yields down. The chart below shows the yield on the 10-year US Treasury approaching 5.25% again as it did last May. The last run occurred as Ben Bernanke vowed that he would do whatever it took to wring out inflation from the economy.
The yield curve is now moving toward a more normal shape with short-term rates lower than long-term rates. If the trend continues it will be the first time in the history of the series, which dates back to 1954, that we have gone from an inverted yield curve (higher short-term rates than long-term rates) to a positive one without the Federal Reserve dropping the funds rate, according to Paul Kasriel, chief economist at Northern Trust. It means that if the Fed is not going to reduce short term rates, the market must take long-term rates higher. If indeed this happens for a sustained period, it will signal a healthy growing economy. Conversely, no change in the curve from here portends a slowing economy.
It was a slow week for economic data and little insight was gained by that which was released. The National Association of Home Builders’ index for sales of new, single-family homes fell in June to 28 following a reading of 30 in May. That marked the lowest point in the index since February 1991. The trade group’s chief economist David Seiders said “the crisis in the sub-prime sector has prompted tighter lending standards in much of the mortgage market, and interest rates on prime-quality home mortgages have moved up considerably during the past month along with long-term Treasury rates.” These factors argue against a housing recovery in the near future as some have suggested.
On Thursday, the Conference Board said its index of Leading Economic Indicators increased by 0.3% during May following a 0.3% drop in April. The increase shows the economy is improving from its slowest pace of growth in more than four years. Growth in jobs and wages is the big driver in the latest numbers and so important because it buoys consumer confidence and reflects employers’ confidence in their businesses for the intermediate future.
The effects of summer and economic uncertainty will likely hold the stock market in a narrow trading range of 3% for the next couple of months. Earnings reports for the second quarter, mergers, and other company-specific events will create some waves along the way. The economy looks to be gaining strength in here, but the outliers of housing and rising fuel costs pose serious threats. These issues have not yet adversely affected growth, but stock and bond markets seem to be suggesting they may.
We believe that caution remains the best course, but we are not trying to time markets. Investing where values are the most compelling within a long-term global view should keep us in good shape. Have a good weekend.