Mystery Cats, Hares, and Tortoises

What hedge funds have been up to in the currency futures market

Andrew Capon, State Street Global Research
Originally published in the October 2006 issue

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done” – John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1936.

Bears love that quote. It is nicely open-ended and can therefore be used as a broadside against every bugaboo stalking financial markets. Back in the years there were day-traders, foolishly punting on every internet-driven rumor and inflating the TMT bubble in the process.

Today, there are the ubiquitous and proliferating hedge funds, those Macavity’s of modern finance, the “hidden paws” behind every market move. Their “powers of levitation would make a fakir stare/ And when you reach the scene of the crime Macavity’s not there.”

One way to track the elusive paw prints of hedge funds through financial markets is the data on the buying and selling of currency futures issued by the Commodities Futures Trading Commission (CFTC) in the US. Speculativeinvestors tracked by the CFTC built up a close to record short of more than $18 billion in the US dollar at the beginning of June and again at the start of August.

However, with DXY index stuck in a 2% trading range since the start of August, the Macavity’s have pulled in their claws. The CFTC recorded record inflows into the dollar in the week ending September 5th and the short position now stands at $1.8 billion, the smallest since April 11.

State Street Global Markets’ research offers a unique perspective on the behavior of a different group of asset managers, institutional investors. They tend to move more slowly than hedge funds. However, their investment flows do tend to be persistent and clearly have a profound impact on market prices.

The Foreign Exchange Flow Indicator measures hedging flows across 30 currencies. In June and July institutional investors began building a net long position in the US dollar. 120-day flows, our positioning proxy, peaked in the week ending July 28th in the 79th percentile (in other words the net long position held in the dollar by institutional investors had only been bigger on 21% of occasions in the decade long history of the FXFI). This coincided with a near record short held by speculative investors such as hedge funds.

However, in recent weeks institutional investors have steadily reduced their exposure to the dollar, just as speculative investors capitulated and started aggressively buying back their short position. In the last week, US dollar flows were in the bottom quartile and 120-day flows are now down to the 59th percentile. Institutions are selling, but their close to neutral positioning means there is plenty of scope to cut exposure further.

Encouraged by the negative signal from institutional investor flows and an increasingly sickly looking US economy, State Street Global Markets’ macro strategy team has reoriented its recommended portfolio of FX trades to a short dollar bias. The US housing market has been giving cause for concern for some time, with the NAHB Index within spitting distance of levels last seen in the 1990-1991 recession. However, there are now signs that the broader economy is slowing, with the September Philly Fed Survey of manufacturing conditions falling into negative territory.

Financial markets have taken their cue from the data. The long-end of the US Treasury curve has rallied sharply with 10-year yields 25 basis points lower over the last week. The gap between 10-year bond yields and 3-month cash rates stands at -34 basis points.

This degree of yield curve inversion has been the harbinger of recession 48% of the time. Interest rate markets have moved to price in a sharp slowdown in growth. The dollar has not, so far, despite its yield advantage declining. Institutional investors may have got the timing of their increasingly negative dollar bet just about right.

The masochistically-inclined probably need no reminding that there are only six months of limb numbing winter training to go before the Boston and London marathons are run. At the finishing post of the Boston marathon, in Copley Square, there stands a fitting, if rather whimsical, statue recalling Aesop’s fable of the tortoise and the hare. Institutional investors don’t have the glam status of their hedge fund peers, but slow and steady sometimes does win the race.