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GM Fallout: The Hits Just Keep Coming

Rumors of hedge fund losses roil stocks while Treasuries continue to confound and amaze.
Author:

Rumors that one or several hedge funds might have misplayed

General Motors

(GM) - Get Report

roiled the market Tuesday, sending the major indices into a tailspin.

The

Dow Jones Industrial Average

tumbled 1.1% to 10,281.11, the

S&P 500

lost 1.1%, to 1166.22 and the

Nasdaq Composite

fell 0.9%, to 1,962.77.

It was supposed to be one of those quiet days for the market, with no economic news on the agenda and

Cisco's

(CSCO) - Get Report

earnings slated for after the close of trading (the networking giant posted results that slightly exceeded expectations). Traders expected at worst a bit of profit-taking from recent gains. But there was no such thing as uncertainty regarding the health of the financial system caught up with the broader market.

Speculation that hedge-fund group QVT Financial LP endured heavy losses by simultaneously taking a long position on GM's bonds and a short position on the automaker's stock first hit

Deutsche Bank

(DB) - Get Report

, which reportedly brokered the trades. In spite of QVT's denial -- and a similar one by GLG Partners -- Deutsche Bank fell 3.3% while negative sentiment gripped financial issues and pretty much spread to all sectors. The Amex Broker/Dealer Index fell 1.9% and declining stocks outpaced advancers by more than 2 to 1 in both

Big Board

and Nasdaq trading.

Ironically, GM was one of only two Dow components to finish higher, gaining 0.54%. GM shares are being supported by the firm's commitment to pay a fat dividend to its shareholders and by billionaire Kirk Kerkorian's offer last week to buy a 5% stake in the ailing automaker. Its debt, meanwhile, stumbled after being downgraded to junk status last week by Standard & Poor's.

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The impact of the GM/hedge fund story on the market may be as interesting as whether or not the speculation had any substance.

The Conundrum, Continued

As investors fled equities and corporate bonds, the Treasury market was once again the beneficiary of flight-to-safety flows. Credit spreads may be widening, but it's only because the GM story keeps weighing heavily on corporate bonds. While short-term Treasuries have been rising in anticipation of the

Fed

hiking rates to 3.75% by year-end, long-term Treasuries have not been doing their part.

The conundrum, described by Fed Chairman Alan Greenspan in February, persists. The 10-year note had moved ever so slightly lower, while its yield rose to 4.29%, after a strong April employment report and evidence of creeping inflationary pressures last week.

But the yield fell back to 4.22% on Tuesday. Maybe hedge funds, which were the fourth-largest buyers of Treasuries in January, are still at work making bets. Or maybe it's because foreign central banks keep financing the U.S. current account deficit. Equally likely, bond buyers at large remain unconvinced either about the resilience of the U.S. economy or about inflation pressures or both.

"I think it's weird," Joel Naroff, president of Naroff Economic Advisors says of the persistently low yield of the 10-year. "At 4.25% it does not make any sense, especially when the economy is slated to rise 3% quarterly on average, inflation is trending higher and the Fed is likely to raise rates."

Absent any outside factors, if the yield of the 10-year fails to rise substantially by year-end while the fed funds rate approaches 4%, the yield curve would invert, which would signal a likely recession for 2006. But of course, there are outside factors.

The other reason bonds rallied Tuesday was a successful auction of three-year Treasury notes. The participation of indirect bidders, which include foreign central banks, remained very strong at 40.3%.

As foreign central banks keep providing the bulk of the funds to make up for a lack of savings by American consumers, interest rates here remain low and keep encouraging the purchasing of homes. Borrowing from home equity extraction, in turn, has been the backbone of U.S. consumption for the past several years. And U.S. consumption is increasingly benefiting foreign exporters.

Investors will be reminded of this trend on Wednesday when the Commerce Department releases the U.S. trade figures for March. The trade deficit is expected to have widened to $61.5 billion from $61 billion. Some say the deficit could have widened to $62 billion or more, which could further reduce first-quarter GDP growth estimates from their current reading of 3.1%.

How long can this imbalance last? The U.S. Senate, in April, already voted in favor of a bill that would impose 27.5% tariffs on all Chinese imports. Perhaps the threat of a trade war is meant to intensify pressures on China to undo its peg to the U.S. dollar.

But that's unlikely to succeed, according to MG Financial Group currency strategist Ashraf Laidi. "You can't tell a country what to do with their currency, especially when that country owns $200 billion worth of your debt," he says. Many speculate that China may instead show goodwill by letting its currency float a bit more within a set range against the dollar.

So the conundrum is likely to continue for a while. In the meantime, other companies like GM likely will be pushed further aside by cheaper and more efficient foreign competitors.

Once again, even as sales of cars and trucks picked up in April, GM was left out of the race while Japanese manufacturers like

Toyota

(TM) - Get Report

benefited. It bears to mind that what triggered the automaker's credit downgrades was its March warning that profits would be hit by lower sales of its gas-guzzling SUVs.

As the U.S. economy increasingly becomes service-based, many have dismissed the old saying that "What's good for GM is good for America." But what's bad for GM may nevertheless be bad for the rest of the U.S. economy.

To view Aaron Task's take on today's market, click here.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

your feedback.