Hedge Funds Search For Value
Over the past week, we met with many long-only and leveraged investors in London and Cape Town. Several highlighted the chaotic nature of markets, with no clear visibility because of central banks’ seemingly open-ended tightening cycles. We sensed meaningful divergence in opinion. Whereas hedge funds are more open to discuss an eventual turn in the US dollar, not least in light of its significant overvaluation, long-only investors are perplexed by flat yield curves, driven so by increasingly aggressive monetary tightening. These are constraining tracking errors, reducing capacity to seek value opportunities. We discussed EM bond tracking error caps here, as an example of these trends.
The last time EUR holdings were this short was during the sovereign debt crisis in 2012. The main difference is that the USD was significantly cheap then, between 5-10% undervalued, whereas it now appears 22% overvalued.
Investors are short EUR for at least three reasons, in our view. First, because it remains unclear how serious the European Central Bank is about its inflation-targeting regime. Headline inflation in the Eurozone is forecast at 8.1% for 2022, 5.5% in 2023, and 2.3% in 2024. Second, worries over the potential for geopolitical escalation and any consequent impact on the energy market may deem monetary policy useless, especially were winter in Europe to be exceptionally cold. Lastly, Italian elections this weekend could add to fiscal uncertainty, as many of the post-pandemic programs are well underway.
Generally speaking, the feedback from our meetings this week was that hedge funds see the combination EUR valuation and positioning as an attractive opportunity to (eventually) consider buying EUR, as well as other G10 currencies, perhaps most notably the yen: investors have reduced short yen exposures from -1.5 scored holdings in the spring to as low as -0.5 in August
USTs: BoJ Intervention Important, The Fed More So
We see five factors impacting UST liquidity: 1. Fed balance-sheet reduction; 2. Foreign central bank activity; 3. Heightened regulation/supervision; 4. A lack of interest in the new repo facility; and 5. Unprecedented front-end demand. Liquidity in the market – measured as UST yield spreads from fair value – is now as poor as during the Great Lockdown.
We think the Fed’s balance-sheet reduction is more significant than worries about other central banks’ USD selling. According to our calculations, the breakdown of UST holdings is $13.7trn in the market, $5.6trn held in the System of Open Market Accounts (SOMA) at the New York Fed, and $3.9trn held by foreign central banks (see chart on p. 4, preceding link). The monthly $60bn SOMA balance-sheet reduction is, in our opinion, more important than any eventual bond sales by foreign central banks. Nevertheless, worries about central bank unwinding and sanctions risk may continue to weigh on market liquidity.