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Hedge Funds in Asia

Wednesday, March 16, 2011

Yen Carry Trade End Likely to Hit Hedge Funds Hard

"Men are not prisoners of fate, but only prisoners of their own minds."

Franklin D. Roosevelt (1882-1945) U.S. President

The Yen currency rate is on the move and taking no prisoners. The script is the same. Previous crises, like the 1987 stock market crash, the 1998 Asian Crisis then in Sep 2008 following the Lehman collapse and onset of the 2008-2009 Credit Crisis all led to the yen marching higher.

Fundamentally, risk-averse Japanese investors repatriated vast portfolio assets back to Tokyo from overseas accounts, often with a bit of a lag. This included big institutions such as insurance companies and pensions. But it also extends to retail investors too.

The sheer size of the moves taking the yen to new highs across a whole host of cross rates is unprecedented and is likely to have steamrolled a number of hedge funds and other investors that have played the carry trade (short yen) for months (and years) utilizing low cost borrowed fund to leverage the trade. Many now face the stark reality of imminent margin calls and the forced selling of other liquid assets to raise cash. So much for all those that interpreted recent tragic events as a yen "selling opportunity".

Japanese retail investors in their search for global yield are or were an important component in the global carry trade. This involved borrowing funds in a low interest rate currency to purchase an asset in a higher yielding currency. Over the last 10 or so years Japanese "orphans and widows" piled into Aussie, South African and Brazilian bond funds. These were eagerly pushed by domestic brokers, banks and insurance companies eager to drum up business against formidable postal deposits and in spite of miniscule interest rates afforded by domestic JGBs (Japanese Government Bonds).

Once the natural and man-made catastrophes hit a flight to safety was triggered. Many accounts sold off.

Aside from bonds, Japanese institutional investors were big buyers of structured products; big buyers of sub-prime CDOs, European equities, U.S. municipal paper and USTS. Again, once disaster struck they sold.

Additionally, local banks in Japan are known to hold about $1 trillion worth of Japanese equities on their books. For many of them the all important "uncle point" or breakeven for them on the TOPIX Index is at 800. This may explain why the BOJ is believed to have bought aggressively various Japan equity-related ETFs once the index slumped to around 725 on March 15. The BOJ is now expected to have spent $2.6 trillion in price support activities in stocks and bonds to lift markets and reverse the negative price spirals. But even they might be running out of fire-power.

Anecdotal evidence suggests that some of the biggest hedge funds (based in Greenwich, CT and Chicago) have been the biggest players in the Japan yen trade. Expect possible big losses to be reported in the March end performance numbers, in much the same way that there were divergent performance numbers during the previously mentioned crises. Brave players will already have pulled out and will be playing a yen-trend buying game short-term. Mahalo.

Saturday, March 12, 2011

Tough Times

"Old age is not so bad when you consider the alternatives".

Maurice Chevalier, (1888-1972)


Price and liquidity dislocations are almost certain in the aftermath of the devastating Sendai Earthquake and Tsunami. Illiquidity in certain securities, a rush for cash from local institutional investors (including insurers and pension funds) and a wider dispersion of near-term performance returns now face hedge funds trading Japanese financial and commodity markets.

In the wake of generally poor performance over the last few years the chances are, this will be lead to even poorer numbers and possibly overseas investor redemptions, until the situation becomes clearer.

Liquidity will be a primary consideration along with damage assessment and control for a number of corporations. The initial fallout saw the yen move higher on short-term repatriation of funds as corporate Treasury departments dumped liquid investments (often $ related) and transferred fund back to Tokyo or Osaka parent company accounts, in a button-down the hatches approach. Ironically the yen rate rallied, although this is likely to be short-lived as a longer term decline seems more than possible in the months ahead. This could be a massive move and one of the major macro plays of 2011/12.

An emergency meeting of the BOJ policy members is heavily favored to sanction massive relief monies to repair the damage done to Sendai and surrounding areas; to enact more quantitative easing; and, to possibly set up additional provisions to ensure that Japan Inc. can access cheap funds at this time of need and turmoil. The latter is likely to be in the order of $24 billion to $37 billion in funds according to the BoJ.

Increases in government spending will continue to strain already stretched fiscal balances and likely lead to greater suspicion that sovereign debt will again be downgraded. Again this should have implications on the yen currency rate.

On the news of the national disaster a number of larger industrial companies closed operations in the norther prefectures to ease potential strains on the nation's electrical grid as reported damage impacted nuclear facilities.

Today, nuclear power accounts for 30% of the nation's power needs so that the reality exists for power outages across the national grid. It will take time for many of these larger industrial companies like Toyota and Honda to get back to full production as damage assessment takes place, especially with quake aftershocks now underway.

A more sinister eventuality may involve fear that one of the 6 reactors in the area begin to melt down. This may provoke panic and could actually lead to mass emigration should a disaster scenario start to unfold. There is likely to be movement out of Tokyo to other more southern cities in the short run as the population tries to flee. Expect too the airport infrastructure too, to be overwhelmed as people try to leave the country.

On a consumer level, there are already reports of hoarding of staples. Consumer sentiment will certainly falter dragging down purchases of consumer durables and luxury items. Most Japanese do not typically store much food given the small living space and a preference to buy perishables on a daily basis. Short-term, expect local convenience store shelves will empty out of canned goods, rice cup noodle, bottled water etc.

Longer term logistical issues should solve these problems as long as the banking system is functioning freely and there are no bank runs. In the countryside, this remains a real possibility especially if the earthquake aftershocks continue throughout the country.

While many hedge funds will argue that now more than ever there will be winners and losers in assessing investment opportunities, the net effect will be to initially dent GDP in the current and near quarter. Looking ahead, one has to ask the question whether that northern part of the country will ever recovery not only in terms of economic growth but in terms of being able to re-populate.

My guess is that like in the wake of the Katrina Hurricane in New Orleans many younger people will simply leave the area and possibly the country too. Again, the parlous state of Japanese demographics will come to the fore. How will be willing to pay ever increasing taxes to fund reconstruction and the revitalization of the country? Certainly, no "old" Japanese politicians will be brave enough to face that issue today. They have not been in the past. It would be political suicide to do so. Mahalo.