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Volatility Up, Leverage Down; Barclays Economists Expect Turning Point

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NEW YORK (–Plenty of liquidity with no threat of inflation, a circumstance that was useful to some hedge funds in the past two years, can no longer be expected. But changes in the economy may be beneficial to other strategies.

Consumer price index data released today confirmed that prices are moving up at a swifter pace. Monetary policy has become less accommodative, and the threat of inflation will cause the Federal Reserve to tighten some more, said Larry Kantor, chief economist and market strategist at Barclays Capital, speaking at a conference.

Global demand is pushing up commodity prices. In the United States, growth of real output has slowed down, while demand is going strong, giving inflation a boost.

The Fed’s tightening of rates so far has not shown an effect on spending or credit growth or asset prices, said Mr. Kantor. Hence it has a long way to go.

New Environment

In view of these conditions, recent moves in long-term yields and sell-offs of bonds appear to be just the beginning of a trend. “We expect much more to come,” said Bulent Baygun, head of U.S. fixed-income strategy at Barclays.

As for foreign exchange markets, volatility is going to increase dramatically, said Steven Englander, Barclays’ chief FX strategist for the Americas. He sees market participants acting as if the placid environment is going to continue, even though that is very unlikely.

“There is a gap between actual volatility and what we think it should be,” he said. Barclays favors a conservative trade of buying two months’ volatility rather than directional bets.

As rates increase, there will be a negative impact on asset valuation and liquidity, said Mark Howard, Barclays’ head of credit research. The cost of borrowing is going up. Highly levered players among hedge funds and proprietary trading desks may have to reduce their indebtedness.

The carry trade, for instance, which was a source of profit for hedge funds in recent years, already is on the wane. And fixed-income strategies, which tend to use a lot of leverage, could be hit by a one-two punch: falling bond prices and high borrowing costs.

But other strategies, like long/short equity, cannot achieve hefty returns in little-changing markets. Greater volatility creates opportunities for them. And, generally it is a boon for brokers, Mr. Kantor said.


Contact Bob Keane with questions or comments at: [email protected].


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