Dysfunctional Pricing Backdrop:

Doug Noland, Credit Bubble Bulletin, www.prudentbear.com  08/15/08

The divergence between underlying fundamental developments and market trading dynamics became only more striking this week. July Consumer Prices were reported up 5.6% from a year earlier, the largest y-o-y increase since January 1991. July Import Prices were up a record 21.6% y-o-y (data going back to 1982). Despite much worse-than-expected inflation readings, the bond market rallied Thursday. Understandably, the market is rather confident the Fed will ignore inflationary pressures as long as employment trends remain weak. And weak they were. Thursday’s report had Continuing Claims for unemployment jumping another 114,000 last week to 3.417 million – the highest level since November 2003. Continuing Claims were up a notable 320,000 in three weeks, increasing the y-t-d gain to 727,000.

The Treasury market is similarly content to disregard what will now be massive ongoing supply of new government debt issues. The federal deficit surged to a record $102.8 billion during July. Spending for the month was up 27.2% y-o-y, pushing fiscal y-t-d spending growth to a positive 8.5%. Receipts were down 5.8% from last July, with fiscal y-t-d Receipts now running 1.0% below a year ago. With two months to go, the fiscal y-t-d deficit has surged to $371bn, up sharply from last year’s comparable $157bn.

And despite troubling developments in the Caucasus and heightened geopolitical tensions, the energy and commodities rout ran unabated. Sure, the global economy is slowing. Yet the dramatic price moves being witnessed are indicative of panic liquidations. It is now clear that many within the leveraged speculating community have suffered huge losses over the past few weeks. For a “community” that was already suffering a difficult year, blowups in the popular energy, commodities and short dollar trades were a decisive backbreaker. Huge rallies in heavily shorted stocks and sectors have added further pain. One can now expect major redemptions at quarter and year-ends, a dynamic that likely ensures recent near-chaotic market conditions become the norm for awhile.

I could go on and on with a discussion on deteriorating fundamentals. The economy is rapidly sinking into what will prove a deep and protracted downturn. Mortgage problems are broadening and worsening, ushering in another leg of financial system and housing market tumult. Financial sector spreads widened meaningfully again this week, and it is worth noting that American Express issued 5-year debt this afternoon at an eye-opening 425 bps above Treasuries. Fannie and Freddie debt spreads also widened significantly this week, as did benchmark agency MBS spreads. A severe Credit crunch is now tightening its noose around much of the real economy.

But, for now, fundamentals are not driving market prices. As I wrote last week, markets are about Greed and Fear – and right now Fear Dominates. Those that crowded into the crowded energy and commodities trade are having their heads handed to them. It is also my sense that the scores of long/short funds are likely struggling as well, as many popular longs are performing poorly and popular shorts are in many cases rising spectacularly. The proliferation of “market neutral” and “quant” strategies created too many players all working cleverly to play the same game. Those ranks will be thinned over the coming months.

Today’s Wall Street Journal chronicled the pain suffered by one particular hedge fund. Launched in September 2006 by a hot UBS trader, the fund immediately raised $3.0 billion. Performance has not met expectations. The fund dropped 34% in 2007 and was down 77% y-t-d through July. Worse yet, investors had agreed to up to a five year lockup. So, even the small amount of their remaining investment is inaccessible.

A lot has been written about all the crazy mortgage and derivative products that were peddled during the Bubble. The incredible mania that engulfed the hedge fund community has not yet received its due. It’s simply hard to believe the days of new fund managers raising billions with extended lockups isn’t coming to an abrupt end. And this is an industry that has for the past few years luxuriated in enormous investment inflows.

While I still read articles noting increased hedge fund investments (see “Muni Watch” above), I can’t believe the more sophisticated money is not running or at least considering heading for the exits. At the minimum, the industry appears to have passed a major inflection point, and one should contemplate that acute Ponzi dynamics could easily materialize. As long as the industry was posting strong returns, inflows remained predictably huge. And robust flows ensured that favored positions could be increased and additional leverage employed – self-reinforcing bull market dynamics. These inflows worked to mark up the value of previous investments, as global securities and commodities markets soared. Investors were completely enamored, while “genius” fund managers raked in billions.

This Bubble will not function well in reverse. And I know the argument that most hedge funds are still outperforming the major equities indices. This just doesn’t matter much. I expect the entire dynamic of this industry to change now that the majority of funds face “high water marks” (losses that have to be recovered before incentive fees can again be collected). After suffering losses, many managers will be tempted to role the dice with investors’ money: “Heads I win and get my head above the high water mark; tails investors lose and I close the fund and enjoy time at the beach.” More responsible managers will operate under intense pressure for performance, forced to place bets but with little room for error. This is a particularly grueling endeavor, and you can rest assured that markets won’t cooperate.

Such significantly altered trading dynamics – not to mention all the burst global speculative Bubbles – create a backdrop where it becomes extremely difficult for speculators to perform. And resulting wild market volatility significantly compounds the pressure and angst. At the same time, many managers had expected to implement various strategies to play the markets’ downside – including shorting, buying put options, writing calls, and certainly playing CDS (Credit default swaps) and various other derivatives. Yet because the Global Leveraged Speculating Community ballooned to unimaginable dimensions, these various systemic “hedges” and bearish speculations all became One Big Crowded Trade. Things are just not going work as expected, a huge problem for investors with grossly inflated expectations.

Wall Street and global speculator community travails are today at the heart of Acute Monetary Disorder. Global pricing mechanisms have turned dysfunctional. Crude oil, the most important commodity in the world, now sees its price fluctuate 30% over a few short weeks – to the upside and then to the downside. Currency values have become similarly unhinged. At the same time, liquidity conditions throughout the global debt markets have turned quite spotty at best. All these factors are working corrosively on the global economy.

The consensus view holds that the Fed should maintain today’s (grossly inequitable) negative real interest rates indefinitely. This, as the thinking goes, is how the financial sector will repair itself. Everything will then return to normal - eventually. Besides, inflation’s won’t be much of an issue. I contend that global financial and economic systems will not begin to “normalize” until this massive global pool of speculative finance deflates. Speculators have for some time been the marginal price setters for global securities, energy, commodities and many other asset markets. This is a precarious dynamic, especially considering that large numbers of speculators are impaired and will now be fighting to save their businesses. Things both financial and economic have become hopelessly unstable. And this Dysfunctional Pricing Backdrop has become the major impediment to unavoidable U.S. and global economic adjustment.