Why the selloff in commodities and emerging markets?

Tuesday, January 22nd, 2008

Jan. 22, 2008 – Phew! Finally some sense prevailed at the Fed with an astonishing cut of 75 bps and 25 bps from Bank of Canada. What a turn of events. There hasn’t been a rate cut like this since the eighties.

Well, here we are in the midst of a global panic, and the media has been all over it, doing its best to carry the news of the panic. That’s why its really important to keep a clear head here, and cut through the clutter.

Emerging markets and commodities are still the strongest bets globally. Emerging markets have been operating from a higher quantum of growth roughly 2-3 times that of industrialized economies. In fact, emerging markets have been dealing with inflationary pressures. A recession in the west relieves some of that pressure, and that is good news. Fact is, the BRIC will still be in need of the raw materials, metals, oil and food, and that demand growth is expected to continue well into the next two decades. So why are they selling off?

The headlines say that demand from emerging markets for commodities will decline and that’s why they are getting hit hard. The real story is that they have been the best performing assets out there, and that is the easiest place to raise cash given the outstanding obligations of the credit market. Those responsible plain and simply need the cash, to refinance their obligations, and to shore up their balance sheets.

Who is doing all of the dumping of stocks? It is most certainly NOT you and me, or the average investor. We are just supposed to stand by and watch this happen.

Its a cabal of large institutional so-called ’smart money’, hedge funds, and currency traders that have driven this market to its present levels.

The credit market (subprime) meltdown, and the credit default swap meltdown, with the failures of MBIA, AMBAC, and ACA, that is following on its heels is the first part of this. The losses at the investment banks are precipitating the repatriation of capital in order to shore up balance sheets. The large proprietary traders are selling off their fundamentally strongest holdings with the biggest gains, in such things as commodities and emerging markets, to accomplish this. This amounts to a giant MARGIN CALL against these obligations. So, Canada and Emerging Markets are not selling off because there is something terribly wrong with them; it is because the biggest players need to get their hands on cash.

Cut through the clutter and you get to the unwinding of the carry trade. This most likely is the largest contributor to the ’round the world’ sell-off.

The slide of the dollar as a result of out-of-sync interest rate cuts, the late start in cutting rates by the Fed to get around the subprime and CDO meltdown, followed on by the ECB and BoJ’s reluctance to cut rates or print money is now leading to a wholesale unwinding of yen/dollar carry trade. And it is BIG. This, in our humble opinion, is the real source of indiscriminate selling of equities which explains why we have seen the kind of volatility we are seeing in the BRIC, emerging markets, and Australia and Canada.

Here’s what’s at the heart of it.

Yen hits 2-1/2-year high vs dollar as stocks slide

Tuesday January 22 2008

By Masayuki Kitano
TOKYO, Jan 22 (Reuters)
…The dollar hit a 2-1/2-year low of 105.61 yen on electronic trading platform EBS early on Tuesday, but later pared its losses and stood at 106.16 yen as of 0322 GMT…
The euro fell to a five-month low of 152.32 yen on EBS, while sterling fell as low as 204.87 yen the lowest since April 2006. They later rebounded off those lows.
“…It’s a combination of carry unwind and repatriation, as well as little or no chance of rate hikes being priced into the high-yielders,” says Gerrard Katz, head of North Asia FX trading at Standard Chartered.
“…Yen carry unwinding might, say, account for about 5 out of 10 of the entire move, with short-term speculators accounting for the other 5 or a bit more,” said a vice president for foreign exchange sales at a European bank…

Euro Falls to Five-Month Low Against Yen as World Stocks Plunge

From Bloomberg – Jan. 21 (Bloomberg)
“…What we are seeing now is investors pulling out of their profitable trades because of risk aversion,’’ said Bilal Hafeez, London-based global head of currency strategy at Deutsche Bank AG, the world’s biggest currency trader. “You see the euro coming off, a decline in emerging-market assets and a rally in the yen.

They are typical signs of carry trades being unwound…’’

“…Investors are likely to continue to liquidate their carry trades in coming weeks, said Neil Jones, head of European hedge fund sales at Mizuho Capital Markets in London. Jones predicts that a weekly close below 154 yen (vs. Euro) will “trigger a wave of sell signals’’ for the euro. He said the yen could rise to 100 per dollar by the end of March…”

To wit, in advance of the unwinding, you can bet that some of these ’sophisticated’ investors who borrowed in yen to invest in higher yielding opportunities elsewhere, covered their own backsides with short positions which they will undoubtedly cover once they are through unwinding their yen carry trade bets that are taking the market down. Hold on to your seats for now…and bet on a bounce at the other end.

This may prove to be the contrarian opportunity of the year to get some (more) exposure of those hard hit commodities and emerging markets. As per Dennis Gartman and Doug Kass, lets be careful out there.

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