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Selling Unwinds as Volatility Abounds

Global rate hikes put 'carry trades' in peril, but U.S. stocks mount a big comeback.

Global central bankers served up a cocktail of coordinated tightening Thursday, leading to dislocations around the world that featured falling commodities markets and a rising dollar. The stock market's late-day rebound took some of the sour taste from traders' mouths. But Thursday's volatile action globally shows the downside of risk rebalancing as several "winning" trades have become losers.

"You have the perfect storm going on," says David Greenwald, partner at Scalene Partners, a currency-focused hedge fund. "The driver here is world interest rates," and people are getting pummeled by positions they put on at the end of May.

The most-damaged positions included being short volatility, going long the euro vs. the dollar, long the yen and long Asian equities. None of those trades are working, as investors watch their other leveraged investments in commodities, emerging-market and high-beta U.S. equities slip away as well. The U.S. stock market's recent gyrations only point to the volatility such unwinding creates.

"That is a bad scenario ... that is a potential 1997 scenario," says Greenwald, referring to the so-called Asian contagion that roiled financial markets until (and definitely including) the Russian debt default and collapse of Long Term Capital management in 1998.

History certainly might not repeat itself, and most emerging markets are in better financial shape now than in 1997-98. And while the "contagion" snowball may be forming, the stock market's late-day rebound may suggest that it hasn't started down the hill. Maybe it never will.

After falling 173 points earlier, the

Dow Jones Industrial Average

closed up 0.07% to 10,938.82, ending a string of four successive declines. The

S&P 500

, which fell to its lowest point of the year at 1235 intraday, finished up 0.1%, at 1257.93. The


lost 0.3% to 2145.32, but finished well off its intraday low of 2100.

Technically speaking, bulls were calling Thursday's session a "successful retest" of the market's May lows and said the intensity of midday selling was the kind of "climactic action" typically associated with a market bottom, at least short term.

Still, Thursday shows that the markets can approach a tipping point if only a few elements take unpredictable turns.

Winding Up for the Unwind

"It certainly seems like the unwinding of troublesome positions is going on," says Scott Frew, general partner at Glastonbury, Conn.-based hedge fund Rockingham Capital Partners. "And the cost of the carry, just about no matter what currency you're borrowing, is going up."

Seven central banks raised interest rates in the past 24 hours, including the European Central Bank by 25 basis points to 2.75%; Denmark by 25 basis points to 3.00%, India by 25 basis points to 5.75%, South Africa by 50 basis points to 7.50%, Thailand by 25 basis points to 5% and Turkey by 175 basis points to 15%. The Bank of Korea surprised with a 25-basis-point hike to South Korea's overnight rate to 4.25%. (If three is a "trend" of central bank tightening, seven is an epidemic.)

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The ECB not only raised its key interest rate by just 25 basis points, it surprised markets with dovish remarks about future rates. Many economists believed the ECB might go 50 basis points after some hawkish talk by bankers last month. The surprise drove the value of the euro down vs. the dollar -- flying in the face of

general bearish consensus on the dollar. The euro fell 1.16% to $1.2652 Thursday. The dollar gained 0.64% against the Japanese yen to 114.17.

So, just as the


ramps up its inflation-fighting rhetoric -- with more coming Thursday from Fed governor Donald Kohn at his Senate confirmation hearing to be Fed vice chairman -- the ECB is tempering its rate outlook, giving the dollar an extra boost.

All of the stock indices tied to the countries that raised interest rates fell Thursday, but Asian equities markets stood out on the downside. Hong Kong's Hang Seng fell 2.32%, while Japan's Nikkei fell 3.07%. The Seoul Composite fell 3.45%.

"Especially in Asia last night -- margin call-forced liquidations seems like what was going on," says Frew. Investors use the carry trade -- borrowing money at low rates to invest in higher-yielding assets -- to take on leveraged positions not only in emerging-market stocks, but also in energy and metals as well, he says. Those assets were suffering again Thursday.

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

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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


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

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Procter & Gamble

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Apple Computer

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In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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