At
the time of writing, the US dollar had plunged by over JY20. What caused this
"extraordinary volatility" in the foreign exchange markets?
Hedge funds reduce their dollar holdings
A hedge fund is a generic name for a variety of relatively unregulated investment
structures, which seek to provide high returns to institutions and very rich private
investors. What hedge funds generally have in common is that they employ sometimes very
high leverage (borrow a lot of money), in various ways, to seek to enhance returns. Until
recently, leverage allowed hedge funds to control several trillion dollars in assets. They
were dominant market players in the emerging markets, high yield debt and mortgage
derivatives. Hedge funds have sustained considerable losses as a result of their
investments in emerging markets - notably Russia - as well as in the bond market. In order
to cover these losses, they have been reducing exposure to the US dollar.
Banks in difficulty
Hedge funds borrowed money in one way or another from banks. Some banks not only lent
money but also invested as shareholders in hedge funds. Italy' central bank had USD250
million; USD150 million as a loan and USD100 million as a shareholding, of the country's
foreign exchange reserves involved in Long Term Capital Management, a high profile hedge
fund. UBS, a major Swiss bank, had a far larger involvement. LTCM's recent near collapse
could have taken world markets with it were it not for a USD3.5 billion rescue package,
brokered by the US Federal Reserve, and paid for by fifteen major financial institutions.
Could the US face a credit crunch?
Banks are now less able and less inclined to lend money as a result of their large losses
on speculative loans to hedge funds. The fear is that this may lead to a "credit
crunch". In Japan, banks are almost unwilling to extend loans to ordinary businesses.
If this behavior spreads to other countries, companies face seeing their businesses
contract because they are unable to source new capital. This may lead to job losses, with
the unemployed unable to pay off their mortgages, further hitting bank assets in a
downward spiral.
Although the severity of the situation facing the Japanese economy is widely known, the
fear over the last few days has been that this sort of situation could occur in America
with calamitous effects on global economic growth.
Interest rate expectations move against the dollar
Due to the Federal Reserve's decision to cut US interest rates by 0.25 percent at the end
of September, the market expects that US interest rates will fall sharply. Falling
interest rates make holding the US currency a much less attractive bet for currency
speculators.
Tentative signs of reform lifts sentiment towards yen
As the situation in the US has deteriorated, there have been tentative signs of an
improvement in Japan. This has encouraged hopes that the Japanese authorities could
finally formulate a set of policies to bailout the recession-hit economy. The key to
enjoying the continuing favor of the currency markets will be the government's swift and
successful implementation of these strategies.
Summary
The prevalent opinion is that the spread of credit crunch is a risk only, and it is not
the central expectation at this time. Central forecasts are not for a further dramatic
decline in the US dollar. However, the full extent of the hedge fund unwinding is not
fully known, and currency movements are likely to remain unpredictable in the short term.
Kenji Steven is a consultant with Stirling Macguire Asset Management
(Japan) Ltd.
At
the time of writing, the US dollar had plunged by over JY20. What caused this
"extraordinary volatility" in the foreign exchange markets?
Hedge funds reduce their dollar holdings
Could the US face a credit crunch?