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How the Bond Markets React 05.27.05
Nothing ado about Something
I'll be the first to admit, there is no love lost between this column
and the Federal Reserve Chairman Alan Greenspan. I bow to this learned man
for all the right reasons, many of which are becoming harder and harder to
find, while I pan him for much more.
Back in the beginning of May, Mr. Greenspan spoke via satellite to
bankers in Chicago. During that transmission, he noted that he was worried
about the derivatives markets. These markets operate far beyond the reach
of the average investor and because of that the Fed chairman mentioned his concern. It however
drew little attention. The derivatives market, for those who don't know is basically a secondary market, financial type of contract that is often a bet on interest rates and time.
His comments should have been reacted to much the way tout television
walks up the hype for each interest rate hike. If they had been taken to
heart, stocks would have sold off instead of rallying on a week on no real
news, good or bad.
Worse yet, bonds will, if the Mr. G.'s concerns are grounded in fact,
sell off strongly driving prices down while sending yields higher. All of
this concern is based on the rather obscure collateralized debt obligation
market. According to Greenspan, hedge funds are a
necessary financial tool that provides services and therefore should not be
regulated. The Security and Exchange Commission, however would like to see hedge
funds, one of the primary uses of CDOs to be more forthright and transparent in their dealings. This is largely because of the ripple effect such trouble in these markets could cause for the rest of us mere mortals.
Should a large derivatives dealer decide that the losses they had been experiencing of late were too
great and sell a major position, more than bonds would experience
difficulties. Many hedge fund managers offset these risky exposures by short
selling stock. If Greenspan's worries become reality, both the fixed income and equity markets would fall and fall fast.
Immediately following the speech, according to Jim McTague of Barron's.
Greenspan suggested that even though he was worried, he did not see a
crisis looming. The worry is real and the warning he was making to banks is simple: be
prepared to get out of the way. The reason is the continued flattening yield curve
that is accompanied by a Fed tightening. These are not normal times and the belief that Greenspan and company has finished raising interest rates is crazy talk. Not just yet.
The problem is not when, but who. Somewhere out there, some hedge fund manager knows the choke point and will begin the selling. The reasons for it might come from a large client pulling out; it might come from depressed
credit ratings in a specific sector; it might come from a margin call. No
matter the origin, the problem will be widespread across many market
hurting more investors than the moneyed few.
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