With all of the anti-hedge fund stuff out there right now, we wanted to pass along part of letter from CMT Chief Market Strategist Mike O’Rourke:The “Bond Vigilantes” of yesteryear have given way to a new nimble and more aggressive disciplinarian who employs derivatives to get his point across instantaneously – the “Hedge Fund Vigilante.” In the past, Bond Vigilantes would sell Treasuries aggressively to express their unease regarding concerns such as inflation or the deficit. The volatile price movement would serve as an early warning system, or radar, to policy makers that the ship needed to be steered back on course. Market professionals correctly view this in a positive light, because it aids in preventing small problems from snowballing into big ones. It generally draws attention to a problem at a point when it can be fixed, before the point of no return is reached. Hedge Fund Vigilantes are the 21st century descendents of the of the Bond Vigilantes. The tools and the tactics are different, but outcomes are similar. It is an undeniable fact that the Hedge Fund industry is larger and a more influential part of trading activity across all asset classes today than during any other bear market or recession in history, including those that occurred during the 2000-2002 time frame. One also cannot forget that with this large asset pool, leverage can be used. The ability to use swaps and derivatives permits the easy movement across a wide variety of asset classes. In effect, trades that would not have been made in the past because there was no market mechanism to do so are made today on a daily basis. Throughout history, the speculator’s job has been to identify a mispricing and position himself to profit from it. The profit incentive is part of the adjustment process. In most cases (the exception is the financial panic), the fundamentals need to be on the side of the speculator. The quicker the price adjustment occurs, the quicker stakeholders and policymakers recognise the course must be righted. It often appears politicians need to be scared into making the tough choices.
The Greece situation serves as an illustrative example of why markets and speculators generally work. Although the Greek problem is by no means resolved, the signs are out there that the problem is not only being taken seriously by the Greek government, but also by its EU brethren. Greece continues to ratchet up the level of cuts necessary in hopes to appease the investment community. Today, Greece’s 5 year Sovereign CDS settled at 293 basis points. They started the year at 281 basis points and peaked in late January at 425 basis points. Needless to say, the problems are not resolved and more work needs to be done, but as Greece makes and implements its hard decisions, the markets will continue to respond accordingly.
Vigilantes are not benevolent. They are the market economy at work. There are also certainly cases where activity is malicious, just as you will find in any other area of business (or government). At its best this process has uncovered outright frauds. The trade in the Financials in the panic market of the Fall of 2008 are the example of when this process did not work. While we would not argue that healthy institutions were taken down, we believe the potential was there. The primary breakdown in 2008 was not in the activity of speculators (although they did not help their own cause), but a failure of market structure. The OTC derivatives market today is still in its infancy. The lack of regulation and lack of transparency fuelled the fear, and still do today. Reporting, position limits, and standard collateral requirements are all measures that would have created transparency and also increased the cost of entry on such positions. On more than one occasion, we have heard of bullish investors who have long sovereign CDS exposure, because it is an inexpensive hedge for tail risk. Once the market juices begin flowing, the volatility picks up and the story enters the news cycle, policymakers on all fronts take notice. These days, it has become common practice for the regulators to start sending out subpoenas. As one might expect, it looks like a witch hunt. The answer is simple – if the proper financial reform were passed to increase transparency, impose position limits and standardize collateral requirements, the subpoenas would not be necessary. The subpoenas are a sign of the transparency that regulators lack, imagine how other investors feel. These vigilantes serve a good purpose and are here to stay so the market structure issues should be resolved sooner rather than later.
Returning to the Greece situation, as we have stated in the past, we did not believe Greece was beyond the point of no return. We believe the Vigilantes have done their part to begin righting the course. The common retort is that if Greece (and other problem nations) tighten the belt, it will hurt growth. The analogy we often hear about the long term deficit problems is a car driving off a cliff. Sticking with that theme, the austerity measures equate to veering off into a ditch, in some cases, you may hit a tree, but the ditch is better than going off the cliff. Investor interpretation will also hinge upon how efficient an allocator of capital one believes the government is. If one does not believe the Government is a good allocator, they should view the spending cuts as eliminating a waste that most investors believe bloats government budgets. From our perspective, we have to admit we get enthused when we see hard decisions being made and waste being eliminated. That is what helps create the strong future fundamentals investors should be looking for when allocating their own capital.