The Great Global Short-Covering

The Dollar and Yen aren't rising on a vote of confidence, but forced short-covering by investors worldwide...

BEFORE WE TURN to the worst global financial crisis in history – and how bad it ould become – the great cash freeze of 2008 just hit Australia, writes Dan Denning in Melbourne for The Daily Reckoning.

Today's Australian papers tell how fund managers AXA, Perpetual, and Australian Unity have frozen redemptions from their mortgage funds. Uh oh...

At least $4.1 billion in investor funds have been frozen overnight. It's an effort to halt the migration of investors from non-guaranteed mortgage funds toward government guaranteed bank accounts.

And notice that those seeking redemptions are not referred to as "depositors" but as "investors". That's a crucial distinction.

The fund management industry in Australia (and around the world, to be fair) has thrived by promising investors income, capital gains and safety. Normally you'd expect to get only one or two of those benefits from a single investment. But getting all three? Hmm. You can find a holy trinity in theology – where one entity can exist in three different forms (y'know, the Father, Son, Holy Ghost).

But in the investment world, we've yet to see any single kind of messiah investment than be all things at all times to all investors.

Enough of theology. What you're seeing now is a financial effect with a political cause. Investors are behaving in a perfectly rational manner by shifting their assets from uninsured vehicles to insured bank accounts. If the government wants to change the behavior (other than the simple coercion of freezing redemptions, the rational action taken by the fund managers) then it needs to change the incentives.

That is, the fund managers either need to guarantee their products or secure some kind of emergency funding from the government or the Reserve Bank to ensure account holders they'll be able to get their money back. Meanwhile, the unintended consequences will continue to unfold. If the mortgage funds provide funding for commercial and residential property development, won't those funds now be much harder to get? That won't be good for property...

Over in the share markets, the ASX opened with cautious optimism, following New York's overnight lead again. But it has since turned down as Japan sank another 10%. So let's take a step back from the day-to-day trading action and remember what's going on.

The bankruptcy of Lehman Brothers has kickstarted a giant global de-leveraging. It's driving the Yen and the Dollar up, while commodities, shares, all other currencies and nearly everything else – including Gold Bullion – becomes much cheaper in cash terms.

"The Dollar and the Yen are rising in a massive, global short squeeze as investors and speculators are forced to delever," writes Randall Forsyth in Barrons. "Borrowings effectively are short sales of a currency. Repayment means covering those shorts, or buying back those currencies. Both the dollar and the yen have been used to fund investments, so they're the objects of buying – not as vote of confidence in the US or Japan, but forced short-covering."

All those borrowed Dollars and Yen first found their way into shares and commodities and foreign currency funds. But who borrowed them? Hedge funds mostly (hedge funds run by banks, insurance companies, and private individuals). And how do you repay borrowed money? You have to sell your assets.

It's tempting to call the massed selling of stocks irrational. But this is based on some investors looking at stock valuations and finding them cheap on an earnings basis, or looking at the cash on the balance sheet. But what you have here are extremely motivated sellers. They HAVE to sell. It's all quite rational.

Normally, when the seller has to sell, it's a very good time to be a buyer, hence Buffett's chest-thumping op-ed piece. But you don't want to be a buyer if there's more forced selling in the pipeline. And that is now the key question in the market:

How much leverage is left to be unwound?

Well, before the crisis hit, hedge funds controlled $2.4 trillion in investor funds. They would have used that to borrow trillions more (with leverage ratios of 10-1, 20-1, and 100-1). This explains how much "value" was added to global stock and commodity markets since 2003-and how quickly it's disappeared as access to credit evaporated for hedge funds and they faced margin calls AND bans on short selling.

The result? All those assets purchased by hedge funds with borrowed money are being liquidated. And the funds that were not hedged at all (long-only, with massive leverage) are not long for this earth. Who are they going to take with them?

“In a fairly Darwinian manner, many hedge funds will simply disappear,” Emmanuel Roman, co-chief executive officer of GLG Partners Inc., told investors at a hedge fund conference in London. "This will go down in the history books as one of the greatest fiascos of banking in 100 years."

True that. But now governments want to regulate hedge funds. They've already begun to do so by preventing them from shorting financial stocks. But remember, if a hedge fund can't short, it can't really hedge. Performance suffers. Investor redemptions increase. The more hedge fund investors want their money back, the more selling in the markets. The very regulation designed to prevent falling stock prices via short selling may accelerate falling stock prices via hedge fund redemptions.

In fact, only the lock-ups by hedge funds which prevent investors from getting their money back are preventing an even greater pace of redemptions. But when those lock-ups expire, watch out. That's assuming the funds are still operating and haven't suffered irreversible losses.

Either way, you see how a new low on the markets is entirely possible. Indeed, as of late Friday here in Melbourne, it's happening already. But our prediction? Stock markets are going to get a hefty global bounce in November. Perhaps commodities and Gold Prices, too.

There are at least three events on the horizon that could provide the boost. First, if Obama is elected, you have the end of uncertainty about the US election (and some highly irrational optimism that things will now be different, better, and nicer). Second, you'll get a new stimulus plan from the Democratic Congress in the US, which should give stocks a bit of a kick. And third, the big G20 meeting in Washington (where Australia's own Kevin Rudd is headed, too). Something that looks and feels good should come from that.

Those three factors may conspire to produce a convincing looking bear-market rally into Christmas. That would be the sucker's rally of 1929-1930. Or, we could be dead wrong and deleveraging may simply overwhelm everything else.

It's also possible, of course, that the bulk of the hedge fund deleveraging has already taken place. But we're not counting on it.