Butterfly Meltdown Signal

Discussion in 'Trading' started by Dogfish, May 13, 2005.

  1. Dogfish


    Just read this research anyone thinking likewise?

    Butterfly Reflects Fears

    "One of the recent rallying calls in the market has been the fear of a major hedge fund blow up—the question about whether we could have another LTCM was all over yesterday’s press. The market is reacting, as we have seen the market post a rally that was too strong to be solely attributed to a post auction relief rally in the wake of yesterday’s 10yr note auction. Looking at the 2/5/10 butterfly spread we can see that fear reflected in the curve trade.

    The 2/5/10 butterfly spread is a yield spread defined by (2yr yield) – 2(5yr yield) + (10yr yield). The spread tends to shift significantly higher when the market is anticipating, or in the wake of, an unusual but significant market event. That is the curve itself shifts more than two standard deviations from its average position of -19.8bp on significant shocks, although it tends to shift one standard deviation wider on the fear of significant shocks. The only two times in the last twenty years when the spread has traded two standard deviations above its average was in 1988, and 2001. The ’88 widening was a result of LTCM, and the ’01 widening a result of the stock market bursting. The LTCM crisis caused the butterfly to hit its widest point of 34.7bp on Nov 6th ’98. Other significant events have caused the market to shift one standard deviation from its 20yr average, such as the Disinflation worries mentioned by Greenspan in the summer of 2003, and the hedge fund traders front-running the mortgage hedgers in before major of refinancing waves in the fall of ’02.

    The market is currently looking to test that one standard deviation, ‘significant fear’ threshold. The first three months of the year saw the butterfly spread narrowing, and shifting significantly below average, touching -16.8b on 3/25—the week after GM announced their significant losses. However at the end of March the spread shifted direction and has been steepening ever since. Certainly the credit problems at GM and Ford are contributing to the widening butterfly spread, but as it moves higher it could begin to signal the market’s fear of another ‘tail’ event—the likes of which Fed Governor Ferguson warned yesterday that the market is still vulnerable to. The pullback in the commodity markets, the fears about corporate credit and the tightening Fed, all three together suggest the butterfly spread may be setting up to signal some sort of a meltdown—at least a moderate one..."
  2. I'd tend to agree. Last summer the threads on bondtalk.com were saying that Coca-cola, ford and GM were only making profit on the carry trade and currency trading and had no sustainable profit. The thought then was that if rates rose they would be in no uncertain terms screwed. And alas 2/3 so far. I feel that this is the first few pieces of something significant. The struggling hedge funds are no longer under the wing of the fed and will receive non of the sympathy LTCM had.

    If you don't know their story, read "When Genius Failed." At the firm's peak, it had borrowed over $100 billion against a base of $4 billion in equity and had derivative (option) positions for an exposure of another $1 trillion. Great book!


    And if the german governement debt gets downgraded which looks possible, then the hedge fund money piling in there over the last week or so would be the final catalyst for meltdown
  3. How would the fed announcement to roll over its short into long term debt, by reissuing the 30 yr t bond affect your butterfly?

    Where did you get the butterfly?

    I'd like to read a little into its fundamentals.
  4. good info, but did u mean '98 and not '88 ?
  5. ig0r


    Reissuing long bond will put downwards pressure on especially the 10 and 30, bringing yields up and, as long as the yield increases is twice as great on the 10 than on the 5 (which won't necessarily be the case), perhaps pushing the 2/5/10 fly higher.
  6. Dogfish


    Just a typo, says ltcm '98 in next sentence. It was written by refco debt futures research analyst, Lara Akin. I should think the 30yr reissue is being priced in to some extent already, the analysis was only done two days ago. Quite a thought provoking article
  7. just21


    City hedge funds head for domino collapse
    Peter Koenig and Louise Armitstead
    BAD investments by some of the biggest hedge funds in London have triggered unprecedented losses, record demands for money back and talk of a death spiral weighing heavily on stocks and bonds.

    GLG, a hedge fund started in 1995 by a group of former Goldman Sachs bankers, has in recent weeks had demands for more than $500m (£270m) from investors wanting to pull out of its $4 billion market-neutral fund.

    The predicament of GLG, the biggest group in Europe, with $13 billion under management, highlights the stress being felt at many hedge funds in Europe and America after four months of deteriorating results.

    Prime brokers and the credit departments in investment banks have been calling clients to check their capital strengths as rumours of a big hedge-fund blow-out grip the industry.

    London-based Cheyne is thought to be down by at least 10% in its credit fund after the downgrading of debt at General Motors and Ford. Ferox, another of London’s most successful funds, is thought to be down nearly 20%. Bailey Coates, Polygon, Rubicon, Vega, Moore Capital and Brevan Howard are all nursing heavy losses of about 5% each in April. Bailey Coates, whose losses reported in The Sunday Times three weeks ago first alerted the wider market to the industry crisis, has had yet more redemption calls.

    “What you’re seeing is like a run on the bank,” said Narayan Naik, director of hedge-fund studies at the London Business School. “Selling forces more selling and there’s a cascade effect.”

    Although industry experts said there was no hedge-fund blow-out on the scale of Long Term Capital Management in 1998, many are concerned that the worst might not be over.

    “There’s not a panic like when LTCM nearly went bust,” said Naik, “but prices will keep dropping until excess money is squeezed out of the hedge-fund industry and a new floor is established.”

    After performing well in the fourth quarter last year, funds have run into increasing difficulty this year as a downturn in consumer spending has sparked fears of a broader slowdown.

    While GLG reported that one of its key funds was down 5.2%, a Man Group scheme suffered a 3.1% decline and Madrid-based Vega told investors one of its leading funds was down 6%.

    May has also started rockily. Some hedge funds were wrongfooted when Standard & Poor’s downgraded General Motors and Ford bonds to junk levels, and US investor Kirk Kerkorian used the opportunity to buy shares. Bond prices fell and share prices rose, the opposite of what fund managers thought would happen.

    Hedge funds that specialise in convertibles — bonds investors can exchange for shares — have also had a hard time. Funds had bought up nearly 80% of all convertibles, so when their prices fell it turned into a stampede.