WEEKEND ECONOMIST: View from afar

Probably the most important message was the almost unanimous conviction of the hedge funds (those that have survived of course) that 'risk-seeking' trades were the way to go for the foreseeable future. The dominant catalyst is the strong conviction that the recent growth recovery in China is sustainable and will build.

The view on the US was that the data had turned and was either improving or at least deteriorating at a slower pace and that steady progress could be expected, while the problems with the US financial sector had been essentially fixed.
The risk-seeking trades fall into a neat suite of strategies: buy credit; buy commodities; buy equities; buy commodity currencies; sell USD; sell bond markets in countries that benefit from rising commodity prices; sell US bonds but sell the spread between AUD bonds and US bonds.

There were considered to be self-reinforcing opportunities for the 'buy commodities' trade – firstly China's growth momentum would create rising demand and secondly the falling US dollar (USD) would support commodity prices.

The main source of pressure on the USD would be the difficulties experienced with the US government's task of covering the sharp increase in supply of bonds. Yields would rise and the yield increase would be exacerbated if the Fed increased its quantitative easing by accelerating its purchase of bonds. The yield increase would not be enough to attract investors and there would have to be an associated fall in the USD to clear the overhang.

Further difficulties in clearing the bond overhang were the redirection of funds into credit and the sheer reduction in available pools of investable funds as valuations had collapsed. There was, surprisingly, little strong conviction from the USD bears that it would lose its reserve currency status and Asian investors would diversify out of USDs.

A key factor behind this hedge fund enthusiasm was the recent substantial improvement in their access to credit. The Lehmann disaster and the associated dislocation of prime broker arrangements had severely limited hedge funds' access to credit and this had only really eased significantly in the last two months.

The real money managers were generally no where near as confident about the risk seeking trades. They were more circumspect on the China story and certainly more concerned about the ability of the data in the US and particularly Europe to justify the speed with which equity markets had rallied; credit spreads had contracted; bond rates had risen and curves had steepened. Concerns with the US consumer and the European banking system were common areas
of discussion.

It is also reasonable to argue that there will be some 'automatic stabilisers' that ensure commodity prices (particularly oil) and bond rates cannot move too much further. Sharply higher bond rates will undermine the fragile improvement in the US housing market while rising oil prices will reduce the discretionary spending capacity of the consumer. Long consistent upward movements in bond yields and commodity prices can only be sustained in a robust economy that
can withstand the associated feedback effects – the global economy in 2009 and (probably) 2010 does not fit that description.

Concerns with the impact of the inadequate capital base and likely further writedowns of the European banks dominated discussions. The preferred trade of many of these managers was to go long European bonds – clearly implying a much more relaxed attitude towards the likely scope for US Treasuries to increase in yield.

However there was a real indication of frustration amongst these investors implying that they had missed the successful risk seeking trades – particularly in credit. One European manager summed it up by noting that his customers had lost in equities; then switched too late to bonds and lost; and he was now set to move them into credit with potentially disastrous results.

My assessment is that this risk seeking style of trading has some way to run as these 'late comers' ensure that the momentum is extended well beyond the capacity of the underlying economies (including China) to justify pricing. However when it turns the move will be sharp and painful as the economic momentum points to no inflation pressure (falling wages; low capacity utilisation in labour and capital); disappointing growth; and further concerns with bank balance sheets, particularly in Europe.

Those real money managers who had entered the risk seeking trade early are now adopting a much shorter time frame for holding positions. Over the years my experience with these people has been for them to be patient with short term adverse movements in positions. However the poor performance of fund managers over the last few years has given them less latitude to hold positions which have move against them. That suggests that if we are right and the underlying weakness of the economy eventually signals a reversal of the risk seeking trades then there will be less 'stable' hands than in previous market reversals.

One well respected risk manager takes a much more bearish position than the real money managers. He argues that the deterioration in the US economy will have a much bigger negative impact on the 'hold to maturity' loans on bank balance sheets than is currently estimated by the banks in both US and Europe. A sharp increase in write downs probably timed for the fourth quarter of 2009 would precipitate a new highly damaging round of financial sector concern with devastating implications for the risk seeking trades.

This approach seems too bearish to me, although I can only note the strong record of this 'recalcitrant' in the past.

Attitudes toward Australia

Of course, Australia sits at the top of the economies that fit into the risk-seeking investment mode. Buy the AUD; buy commodities; sell Australian bonds and swaps; and buy Australian credit – particularly floating rate government guaranteed bank issues which are generally heavily oversubscribed.

Hedge funds in particular argue that Australians are way too pessimistic about growth prospects in their own economy – the RBA's so called easing bias is not taken too seriously. Investors compare the approach of the RBNZ, which opined that rates may have bottomed only then having to deal with a sudden increase in fixed rates as traders and retail borrowers started bringing forward the timing of rate hikes. In order to discourage any further steepening of the front end of the curve (therefore implying early rate hikes) the RBNZ issue a statement that it did not expect to raise rates before the end of 2010 – the sort of guidance RBA would be very unlikely to ever contemplate. However, maintaining a serious easing bias (with potentially little intention of delivering on it) might be designed to achieve the same objective.

Unfortunately that easing bias does not sit particularly logically with consistent speeches and emphases on 'talking up' the economy. The net result has been that, consistent with the risk seeking trade, (sell bond markets in commodity economies) markets are now pricing in around 200 basis points of rate hikes in 2010 by the RBA.

Customers complained that Australian brokers were promoting the 1 year /1 year long trade when only 100 basis points of rate hikes were priced into the curve out to end 2010 – very unattractive given the subsequent steepening.

Needless to say, my view that rates were unlikely to rise at all in 2010 was treated with disbelief by the risk seeking traders and the common criticism was that Australian's were too pessimistic about their own economy, which surely in the eyes of the risk seeking traders was a classic to buy the currency and sell the bond market. I expect that my careful arguments about sharply increasing unemployment, falling inflation and the potential for increases in mortgage rates by the banks independent of RBA (since vindicated by CBA's move to raise its variable rate 10 basis points) might soon have an impact on even the risk seekers as the short end of the curve reaches ridiculous levels from the perspective of the implied path of monetary policy.

No doubt these risk seekers will have derived some satisfaction from the extraordinary jump in Westpac's Consumer Sentiment Index this week (second largest jump since survey began in 1974); and the loss of only 1700 jobs in May compared to market expectations of 30,000 (range of market forecasts from 15,000 to 50,000 losses).

Our view is the likely demise of the risk seeking trade as the data can not keep pace with the pricing. We are supremely confident that the extent of rate hikes currently being priced into the curve will prove to be wildly exaggerated but given the momentum of the risk seeking trades can not necessarily call that market pricing on rates has already peaked.

Conclusion

Market thinking is currently dominated by the 'risk seeking' trade either by those in the trade or those who angst about being left behind. That situation is likely to persist for some weeks/months until inevitably (I believe) the pace of economic recovery will not match market expectations. At that time look for a substantial market correction and a reversal of the risk seeking trades.

Implications will be more realistic pricing of the likely RBA response (no hikes in 2010) and a lower AUD.

Bill Evans is the chief economist at Westpac.