“Today's managers, many of whom are alumni of the original global macro fund managers, earned their stripes during the ensuing crises and events. While Keynes had his 1929 event to learn about the positive and negative effects of trading on leverage, which he subsequently incorporated into his trading style and translated into future success, today's managers had the 1987 stock market crash, the sterling crisis of 1992, the bond market rout of 1994, the Asia crisis of 1997, the Russia/LTCM crisis of 1998, and finally the dot-com bust of 2000. (See Figure 1) The ways that today's managers look at markets, control risk, and manage their businesses include lessons learned through these important events.
Figure 1 Major Global Macro Events since 1971
The Stock Market Crash of 1987
Although the U.S. stock market crash of October 1987 is now a mere blip on long-term stock market charts (see Figure 2), as indexes fully recovered only two years later, the intensity of Black Monday for traders who lived through it has certainly left its mark. Most notably, the notions of liquidity risk and fat tails were introduced to the wider investment community without mercy. Entire portfolios and money management businesses were obliterated on that day as margin calls went unfunded. Indeed, even so-called "portfolio insurance" hedges didn't work as the futures and options markets became unhinged from the cash market.
Figure 2 S&P 500 Index, 1980-2005
Yra Harris (Praxis Trading) explains in his interview later in this book what he saw that day on the floor of the Chicago Mercantile Exchange:
It was eerie and scary because you just didn't know the extent if everything. People were clearly hurting badly but you just didn't know how badly. I've traded through a lot if devaluations and debacles but I've never seen as many people pulled off the floor by clearinghouses as I did that day. The pit was practically empty, which actually turned into a great opportunity to trade the S&Ps. I went into the S&P pit and starting making markets because nobody else was. Spreads were so unbelievably wide that it was pretty easy to make money just scalping around. Honestly, I couldn't help it.
Global macro managers from the equity stream, including George Soros, got hurt in the 1987 crash. Just prior to the crash, Fortune magazine ran a cover story entitled, "Are Stocks Too High?" in which Soros disagreed with the notion. Days later, Soros lost $300 million as stocks collapsed (yet Soros Fund Management still ended the year up 14 percent). Meanwhile, Tiger Management posted its first down year (-1.4 percent) only one year after an Institutional Investor article, noting Tiger's 43 percent average annual returns since inception in 1980, sparked the next wave of hedge fund launches.
For global macro traders from the commodities stream, however, the 1987 crash served as a windfall event. Paul Tudor Jones in particular was elevated to star status when he famously caught the short side of the stock market and the long side of the bond market by identifying similarities between technical trading patterns in 1987 and the great crash of 1929. (See Figure 3) Jones's Tudor Investment Corporation returned 62 percent for the month in October 1987 and 200 percent for the year.
The year 1987 also marked the introduction of a new Federal Reserve chairman in Alan Greenspan. Greenspan came into office in August 1987 and his first act a few weeks later was to raise the discount rate by 50 basis points. This unexpected tightening created volatility and uncertainty in the markets as traders adjusted to the style of a new Fed chairman. Some argue that Greenspan's rate hike was actually the cause of the subsequent equity market meltdown a month-and-a-half later. Immediately after the stock market crash, Greenspan flooded the market with liquidity, initiating a process that came to be known as the Greenspan put." The Greenspan put is an implicit option that the Fed writes anytime equity markets stumble, in hopes of bailing out investors.
Figure 3 Dow Jones Industrial Average: The Late 1920s versus the Late 1980s
Former Federal Reserve chairman William McChesney Martin famously observed that the job of a central banker is to "take away the punch bowl just when the party is getting started." Alan Greenspan, on the other hand, seemed to interpret his role as needing to intervene only as the partygoers are stumbling home. As he has claimed, bubbles can only be clearly observed in hindsight, such that the role of a central banker is to soften the impact of the bubble's bursting rather than to take away the fuel for the party.
Black Wednesday 1992
The term global macro first entered the general public's vocabulary on Black Wednesday, or September 16, 1992. Black Wednesday, as the sterling crisis is called, was the day the British government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM)-a mere two years after joining-sending the currency into a free fall. The popular press credited global macro hedge fund manager George Soros with forcing the pound out of the ERM. As Scott Bessent (Bessent Capital), head of the London office of Soros Fund Management at the time, noted, "Interestingly, no one had ever heard of George Soros before this. I remember going to play tennis with him at his London house on the Saturday after it happened. It was as if he were a rock star with cameramen and paparazzi waiting out front."
The ERM was introduced in 1979 with the goals of reducing exchange rate variability and achieving monetary stability within Europe in preparation for the Economic and Monetary Union (EMU) and ultimately the introduction of a single currency, the euro, which culminated in 1999. The process was seen as politically driven, attempting to tie Germany's fate to the rest of Europe and economically anchor the rest of Europe to the Bundesbank's successful low interest rate, low inflation policies.
The United Kingdom tardily joined the ERM in 1990 at a central parity rate of 2.95 deutsche marks to the pound, which many believed to be too strong. To comply with ERM rules, the UK government was required to keep the pound in a trading band within 6 percent of the parity rate. An arguably artificially strong currency in the United Kingdom soon led the country into a recession. Meanwhile, Germany was suffering inflationary effects from the integration of East and West Germany, which led to high interest rates. Despite a recession, The United Kingdom was forced to keep interest rates artificially high, in line with German rates, in order to maintain the currency regime. In September 1992, as the sterling/mark exchange rate approached the lower end of the trading band, traders increasingly sold pounds against deutsche marks, forcing the Bank of England to intervene and buy an unlimited amount of pounds in accordance with ERM rules. Fears of a larger currency devaluation sent British companies scrambling to hedge their currency exposure by selling pounds, further compounding pressures on the system.
In an effort to discourage speculation, UK Chancellor Norman Lamont raised interest rates from 10 percent to 12 percent, making the pound more expensive to borrow and more attractive to lend. However, this action only served to embolden traders and further frighten hedgers, all of whom continued selling pounds. Official threats to raise rates to 15 percent fell on deaf ears. Traders knew that continually raising interest rates to defend a currency during a recession is an unsustainable policy. Finally, on the evening of September 16, 1992, Great Britain humbly announced that it would no longer defend the trading band and withdrew the pound from the ERM system. The pound fell approximately 15 percent against the deutsche mark over the next few weeks, providing a windfall for speculators and a loss to the UK Treasury (i.e., British taxpayers) estimated to be in excess of £3 billion. (See Figure 4)
Figure 4 Sterling/Mark and UK Base Rates, 1992
It was reported at the time that Soros Fund Management made between $1 billion and $2 billion by shorting the pound, earning George Soros the moniker "the man who broke the Bank of England." But he was certainly not alone in betting against the pound. While he may have borne a disproportionate amount of the criticism because of his significant gains, the government's own policies are believed by many to have been the root cause of the problem, the speculators merely a symptomatic presence.
The pound eventually traded as low as 2.16 deutsche marks in 1"95 but then rose as high as 3.44 in 2000 as the British economy recovered from recession and Germany suffered from the negative effects of euro integration. (See Figure 5) Some credit today's strength in the British economy with the interest rate and currency flexibility afforded by its position outside of the euro system. This is especially striking when the United Kingdom's economic growth over the last decade is compared to the growth rates of formerly strong euro area countries such as Germany and France.
Yra Harris amusingly claims in his interview that Great Britain should erect a statue of George Soros in Trafalgar Square as an expression of gratitude for taking the pound out of the ERM. Bessent adds, "A lot of credit should go to the UK officials . . . they knew to fold their hand quickly. UK Chancellor Norman Lamont and Prime Minister John Major suffered short-term humiliation for long-term good. I mean, look at the muddle France and Germany are still in."
Figure 5 Sterling/Mark, 1990-2005
Following the sterling crisis, the next systemic event for the global macro community was the bond market rout of 1994, but this time, the outcome was not profitable.
Bond MarketRoutof1994
As the euro project gathered political steam throughout the late 1980s and early 1990s, convergence trades-trades profiting from the convergence of various currencies and bonds toward a single currency and interest rate-became the dominant theme in European foreign exchange and fixed income markets. The early 1990s especially witnessed several strong years in the European fixed income and currency markets. Global macro traders at banks and hedge funds jumped on the trend along with relative value traders and trend followers, who were all heavily long European bonds. Leveraged positions were predominantly taken in the bonds and currencies of the weaker, high interest rate eurozone countries which, after the United Kingdom opted out of the ERM, were Italy and Spain.
Then, in February 1994, Fed Chairman Greenspan surprised the markets by raising overnight U.S. interest rates from 3 percent to 3.25 percent, beginning a series of hikes that served to abruptly end the early 1990s' period of easy money. Given the sizeable leveraged positions that had built up in the falling interest rate environment pre-1994, especially in the budding derivatives market, this unforeseen reversal of trend led to a generalized market sell-off. The 10-year U.S. government bond yield moved from 5.87 percent to 7.11 percent three months after the first hike, and most other markets also suffered trend reversals and declines. Likewise, the European bond trade that had worked so well until this point began to unravel. The sell-off was further compounded as margins were called, leveraged positions unwound, and continued price declines created a vicious cycle of forced selling. (See Figure 6 )
Figure 6 Yields: U.S. 10-Year Treasury, UK 10-Year Gilt, and German 10-year Bund, 1993-1994
Corporations on the receiving end of Wall Street's derivative prowess, such as Procter & Gamble and Gibson Greetings, suffered major losses as their hedges went against them; Orange County, California, the wealthiest county in the United States at the time, declared bankruptcy as interest rate derivative structures imploded; and several well-known global macro funds either closed or went into hiding. Indeed, 1994 was the only down year for the HFR global macro index, which lost 4.3 percent.
Asia Crisis 1997
For most of the 1990s many Southeast Asian countries had currency regimes that were linked to the U.S. dollar (USD) through trading bands that were set and managed by the local central banks. For the first half of the 1990s the USD was falling, improving the competitiveness of the Southeast Asian countries. Then, in 1995, the USD started to appreciate on a trade-weighted basis and especially against the yen, where it appreciated by more than 50 percent from April 1995 to January 1997. Due to their link to the USD, the Southeast Asian currencies appreciated in kind, slowly eroding their competitive advantage. (See Figure 7)
The USD link allowed local Southeast Asian borrowers to access cheaper funds offshore as U.S. interest rates were below local rates and their currencies were essentially pegged. They also borrowed a lot from Japan where interest rates were less than 1 percent and, post-1995, the Japanese clearly had a policy to weaken their currency. Given their confidence in the stable currency regime, Southeast Asians deemed such cross currency borrowing as largely riskless. But expanding current account deficits, along with a rising competitive environment, most notably from China, and a strengthening USD, created pressures in the managed exchange rate system. Towards the middle of 1997, the Japanese banks were forced to increase their asset bases and were thus less inclined to roll over short-term debts. This drying up of liquidity for the Southeast Asian borrowers, coupled with a sudden rally in the yen in May 1997, brought to light some of the strains in the system.
Figure 7 Japanese Yen, 1990-1998
As the risks became increasingly apparent, locals began to hedge their foreign exchange exposure, which meant heavy selling of local Southeast Asian currencies. As pressures on the system built, it became more difficult and more expensive for the local central banks to defend their currency regimes when their exchange rates approached the lower ends of the trading bands.
By July 1997, the Central Bank of Thailand saw its foreign currency reserve position dwindle in a futile effort to defend their currency regime and was left with little choice but to abandon the trading band. Without central bank support, the Thai baht immediately fell by 23 percent against the USD (See Figure 8) Lenders to Southeast Asian countries panicked en masse, withdrawing capital from the region or hedging their currency risk, which further depressed the Asian currencies. At the same time, locals borrowing in U.S. dollars and yen but getting paid in local currency rushed to hedge their worsening foreign exchange position. This led to a systemic sell-off across all Southeast Asian currencies, stock markets, and other assets linked to the former "Asian Tigers," creating a contagion-like" effect. Foreign investors rushed to pull their capital from the region without regard to specific country situations. The Thai baht eventually lost more than 50 percent of its value with other Southeast Asian currencies and stock markets sharing a similar fate. It was like a classic run on the bank, but in this case it was small economies and an entire region.
Figure 8 Thai Baht, 1997
Many economists and institutions at the time blamed the Asia crisis on I the openness of the global capital markets and the herd mentality of speculators. Malaysia's prime minister, Dr. Mahathir Mohamad, publicly blamed George Soros for the economic ills that Malaysia suffered following the crisis and even considered currency speculation a crime. He shut down his country's economy to so-called hot money by instituting draconian capital controls and fixing the Malaysian ringgit to the USD at 3.80. (See Figure 9) As Scott Bessent recalls, it "was slightly worrying [because] it was the first time that someone had actually stopped paying lip service and actually shut down an economic system."
While Soros Fund Management returned 11.4 percent for the month of July 1997 largely from shorting the Thai baht, if profiting from the collapse of the Southeast Asian market deserves blame, then Julian Robertson should have received the lion's share of attention. His Tiger Management made $7 billion in profit after catching Asia crisis trades across currency, commodity, and equity markets. Going into July 1997, the fund's returns were approximately flat for the year on an asset base of $10 billion but after a strong finish, Tiger completed the year up 70 percent.
Figure 9 Malaysian Ringgit, 1998-1998
To say that speculators caused the Asia crisis, though, would be oversimplifying the situation. More likely the local borrowers, who built up excessive foreign exchange exposures prior to 1997 when the system was still largely stable, were also largely to blame. As such, the Southeast Asian governments merit responsibility for running ill-conceived policies that allowed excessive foreign currency borrowing to build up in the first place.
Russia Crisis 1998
The Russia crisis, according to some, was essentially a continuation of the Asia crisis as the Asian "economic flu" made its way around the globe, causing investors to retrench and reduce exposure to riskier investments such as emerging markets. Prior to 1998, Russia was the darling of the investment community as the large, commodity-rich economy emerged out from under the Iron Curtain. But as foreign investors retrenched and pulled their capital from Russia, the deteriorating situation was compounded again by locals moving money offshore and by less-than-perfect government financial management.
As capital started to flee Russia, successive changing of finance ministers, increases in interest rates to incredibly high levels, and various proposals of international bailout packages were all attempted by the Russian government before it finally capitulated. On August 17, 1998, the government of the Russian Federation and the Central Bank of Russia announced a currency devaluation and a moratorium on 281 billion rubles of government debt. The ruble fell from 6 to the U.S. dollar to 20 (and eventually to over 30 in 2002), while the bonds became almost worthless. The Russian stock market index (RTSI$) collapsed from a high of 570 to 36 during the lead-up to the crisis. (See Figure 10) At the same time, many Russian financial institutions immediately became insolvent. This caused ripples through the world financial system, as many institutions had exposure to Russia that was thought to be hedged through derivative contracts with local Russian banks. Rather than being hedged, these positions became the subject of counterparty credit risk when the Russian banks became insolvent, leaving only the losing side of the trade.
Figure 10 Russian Ruble and Russia Equity Index (RTSI$), 1997-1998
The devaluation of the Russian ruble and simultaneous default of the country's sovereign debt caught many macro managers poorly positioned. It also marked the beginning of the end for the great global macro hedge funds, with 1998 denoting the peak in assets for Soros and Tiger (approximately $22 billion and $25 billion, respectively). George Soros made headlines again by losing between $1 billion and $2 billion on a single day (but yet again managed to finish positive for the year, returning 12 percent to investors) while Julian Robertson also took an estimated $1 billion hit in Russia. Tiger's woes were compounded with large losses in other markets, notably yen carry trades. (See Figure 11)
Figure 11 The Dollar/Yen Carry Trade, 1997-1998
As with most major crises, the Russian event created anomalies in other seemingly unrelated world markets. In this case, as investors dramatically reduced overall exposure to risky assets, they moved their capital into on the- run U.S. government bonds in what was called "a flight to quality." As I a result, spreads between the benchmark U.S. government bonds and all lather risk assets widened dramatically, leading the world to its next financial crisis: Long Term Capital Management.
Long Term Capital Management 1998
Although Long Term Capital Management (LTCM) was not a global macro fund, it is worth mentioning for several reasons. For one, the arbitrage focused fund drifted into global macro trades and its subsequent unwind had ramifications for global macro markets. Two, it offers insights into what can go wrong at a hedge fund, as well as shed light on such important issues as liquidity, risk management, and correlations. And three, almost every interviewee in this book mentions LTCM.
LTCM was started in 1994 by infamous Salomon Brothers proprietary I trader John Meriwether, who hired an all-star cast of financial minds including former Fed vice chairman David Mullins and Nobel Prize winners Robert Merton and Myron Scholes (pioneers in option pricing theory and methodology). LTCM started with $1.3 billion in assets from a who's who list of investors and initially focused on fixed income arbitrage opportunities (which had become more attractive as spreads widened after the bond market rout of 1994). The original core strategy was to bet on the convergence of the spread between "off-the-run" and "on-the-run" bonds, as well as other relative value and arbitrage opportunities, primarily in fixed income. Due to the small spread in these arbitrage trades, the fund was leveraged many times in order to generate the 40-plus percent annual returns it posted for the first few years of its existence.
LTCM's success at exploiting these arbitrages caused assets under management to grow at the same time that the opportunities were disappearing. LTCM was forced to increase leverage to maintain returns as well as allocate risk capital to markets and trades that were beyond its original scope of expertise. Going into 1998, LTCM had $5 billion in assets with notional outstanding positions estimated at well over $1 trillion. At the same time, risk arbitrage trades (bets on mergers and acquisitions), directional positions, and emerging market bets became a larger portion of portfolio risk.
As the summer of 1998 approached, global markets became increasingly unsettled due to a combination of the fallout from the Asia crisis and the hint of trouble in Russia. To exacerbate matters, Salomon Brothers, Meriwether's former employer, decided to exit the arbitrage business, closing out similar positions and causing a widening of spreads in LTCM's trades. Russia's eventual devaluation and default then led to a large-scale reduction in risk appetite and a global flight to quality. Long-term fundamental values were deemed irrelevant by investors, causing a further widening of the spreads on LTCM's arbitrage and relative value trades. (See Figure 12) LTCM's losses escalated to worrisome levels.
Given the leverage and size of LTCM's positions, liquidation was all but impossible. At the same time, LTCM's counterparties knew they were in trouble and at risk of imploding, leading them to hedge their own counterparty risk, further compounding LTCM's mark-to-market woes. To mitigate default-and, some would argue, the potential collapse of the world financial system-the Federal Reserve Bank of New York called a meeting with LTCM's creditors and implemented a bailout package. It was yet another iteration of the Greenspan put.
LTCM was at the forefront of investing at the time and offers insight into some of the failings of risk management systems. Risk management systems based on historical prices are one way to look at risk but are in no way faultless. Financial market history is filled with theoretically low probability or fat tail events. In LTCM's case, its risk systems calculated roughly a l-in-6-billion chance of a major blowup. Ironically, however, one correlation the brilliant minds of LTCM neglected to consider was the correlation I coefficient of positions that were linked for no other reason than the fact hat they were in LTCM's portfolio. In other words, their models didn't provide for the LTCM liquidity premium.
Figure 12 Corporate Spreads to Treasuries, 1994-1999
LTCM was a reminder of the notion that there is no such thing as a risk-free arbitrage. Because the arbitrage positions they were exploiting were small, the fund had to be leveraged many times to produce meaningful returns. This put them at risk to their lenders' financing fees as well as general market liquidity. The problem with liquidity is that it is never there when really needed.
Dol-Com Bust 2000
Chairman Greenspan issued his famous "irrational exuberance" speech on December 6, 1996, warning of the perceived overvaluation of the U.S. stock market. Over the next three years, the stock market did nothing but go up, minus a hiccup during the Russia/LTCM episode, which Greenspan quickly corrected by cutting interest rates by 75 basis points. The rate cuts included a famous intrameeting cut normally reserved for emergencies, despite the fact that the U.S. unemployment rate was 4.5 percent (so much for taking away the punch bowl). Meanwhile, !Tom the famous speech through to March 2000, the broader S&P 500 index doubled while the technology stock-laden NASDAQ quadrupled. (See Figure 13)
Figure 13 Boom! 1996-2000
As such, the returns being produced by global macro hedge funds were no longer as interesting to investors as the 50 to 100 percent or more annual returns being posted by some technology mutual funds. At the same, time, the two largest global macro fund managers struggled with the new momentum-driven paradigm. Robertson and Soros both became vocal naysayers of the tech stock-driven rally. It was widely perceived that dotcom and tech stocks were in a bubble but, as shares rallied ceaselessly, it was all but impossible for many investors to jump on the bandwagon. Indeed, Soros Fund Management flipped its position in late 1999, going from short to long high tech stocks, and in the process converted a 19 percent loss into a 35 percent gain for the year.
Julian Robertson, on the other hand, chose to maintain his core theme of long "old economy" versus short "new economy," which led to further losses in 1999 and 2000 as old economy stocks continued to decline and growth rallied. Eventually, Robertson was forced to close Tiger Management as investor redemptions piled up and assets under management sank from $25 billion to $6 billion. Upon shuttering his fund, Robertson remarked in his final investor letter, "As you have heard me say on many occasions, the key to Tiger's success over the years has been a steady commitment to buying the best stocks and shorting the worst. In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much." Ironically, Tiger's final month in operation, March 2000, coincided with the absolute top of the tech stock bubble, after which Robertson's investment thesis would have proven a winner. (See Figure 14)
Meanwhile, Soros's long tech stocks position that had been rewarded so handsomely in late 1999 and early 2000 turned viciously against him after March of that year. Down 22 percent by April 2000, Soros announced plans to change the nature of his Quantum Fund to a lower-risk vehicle dubbed Quantum Endowment. Soros remarked at the time, "We have come to realize that a large hedge fund like Quantum Fund is no longer the best way to manage money. Markets have become extremely unstable and historical measures of value at risk no longer apply”.”
Figure 14 Bust! 2000-2003