Crunch time

Tight credit could mean choppy markets ahead

WALL Street’s extraordinary moves in late November, with three consecutive shifts of more than 200 points in the Dow Jones Industrial Average, have been attributed to a host of factors. Among the most prominent were Abu Dhabi’s investment in Citigroup, the apparent willingness of the Federal Reserve to cut interest rates, and some disappointing profit numbers.

But market participants suggest that November saw a repeat of the turmoil experienced in August. That was when the credit crunch really hit home and the Fed was forced to change tack and cut the discount rate, only a week after indicating that monetary policy would stay on hold. And it was a month that many investors found to be extraordinarily difficult.

What made August so volatile was that investors were forced to unwind leveraged positions—in other words, investments they had financed with borrowed money. Leverage tends to be used in two circumstances. The first is when trends are well established, and investors feel confident they will continue; the second is when the cost of borrowing is low, and leverage is thus a cheap way of enhancing returns. But in August, trends suddenly reversed and the credit crunch made it more difficult and expensive to use leverage. That created a whole bunch of forced sellers.

This time round, it seems that leveraged investors have been forced to cut again. Perhaps the strength of the market rebound in September and early October fooled investors into thinking all was rosy and that the markets were replaying the template of 1998-1999, when Fed rate-cuts after a financial crisis led to the final fling of the great equity bull-market.

But when it became clear in early November that the credit crunch was continuing, that more bad news was due from the financial sector, and that the American economy might be fragile in 2008, investors were forced to cut and run. The mechanics of this process may not be clear for a little while.

As in August, it may well be that a multi-strategy fund (a hedge fund that invests across a range of asset classes) decided to cut its positions. In such circumstances, investors often sell what they can, rather that what they might like to. That can lead to some unexpected market movements.

For example, Bloomberg says Treasury bonds had their best month for 12 years in November. It is not impossible that many investors shorted bonds (betting on yields to rise) at the start of the month on the grounds that inflationary expectations were rising. They would have had to switch tactics very quickly as investors flocked to the haven of government bonds.

Perhaps this will be the pattern for markets for some time: a breathtaking switchback ride as risk-seeking investors try to take advantage of short-term trends (and by their actions, make those trends more vicious). But that does raise the question of why volatility was so low in the period 2004-2006. After all, plenty of hedge funds were in existence during that period.

The answer may well be that credit was easy to obtain during that period. Markets were not only less volatile, they were also rising in unison; everything from the price of gold to emerging-market equities to junk bonds was going up. It is the withdrawal of credit that makes markets volatile, and if investors have become complacent about their ability to get access to credit, the volatility will be all the more extreme. Not until banks become more relaxed about lending money will markets return to their 2004-06 state again.