Selling Unwinds as Volatility Abounds

Gold fell 3% Thursday, silver fell 6.8% and copper fell 6.1% on the day. Oil dropped 0.6% to $70.34, after falling below $69.50 earlier in the day on news that the U.S. had killed al Qaeda leader Abu Musab Al-Zarqawi. Still, energy stocks such as Exxon Mobil (XOM) and Halliburton (HAL) helped pace the stock market's comeback.

The idea that the carry trade is unwinding is not new, but there are carry trades and there are carry trades. Borrowing in yen to invest in Iceland may have ended in March, but that was just the beginning. Going short volatility and making a long leveraged bet on other risky assets was popular throughout the bull market of the past few years.

Several hedge funds shorted volatility in a variety of forms to fund their leveraged bets in various markets over the past couple of years, hedge fund sources say. Investors were hurt on this trade in May, when volatility spiked, as measured by the CBOE Market Volatility Index (an index of implied volatility based on S&P 100 options). But the trade got popular again when the markets showed strength on the first couple of days in June.

"Everyone did the usual, 'It was just a bad market in May,' and put on the same trade, and now they're getting hurt," says one hedge fund manager who declines to be named. He adds that several funds have been deeply dented by this mistake, and have had trouble covering their positions. He declined to name any funds, but said that thus far, no major liquidations or "blowups" were evident.

On Thursday, the VIX spiked to 22.59 intraday, but ended up a relatively modest 3.09% at 18.35.

Clearly, some investors have turned risk-averse lately, as evidenced by the rally in U.S. Treasury bonds as a safe-haven investment. The 10-year Treasury note gained 6/32 in price to yield 5% Thursday.

Still, it's not as if the more speculative hedge fund players are going to abandon the carry trade altogether. Turkey's 175-basis-point rate hike makes the nation just another place for investors to put on a carry trade given the (still) relatively low rates they can borrow in Japan and other markets, notes Greenwald.

"The currency positions are the body of the dog," he says. "The wagging tail is the equity moves."

Speaking of which, the major U.S. stock indices ended the day relatively unchanged thanks to strength in big-caps such as Home Depot (HD), Procter & Gamble (PG) and Apple Computer (AAPL).

>To order reprints of this article, click here: Reprints