The big momentum trade of 2008 is unwinding fast, helping to push battered banking shares upward while adding downward pressure to tumbling oil prices. The trade, which bet energy prices would go higher and bank stocks would crater, has created huge volatility on financial markets and helped wreak havoc on pocketbooks and retirement accounts around the world.
When trouble erupted last summer in the US market for home loans and related securities, investors bet Federal Reserve Chairman Ben Bernanke would be forced to cut interest rates to ease a fast-developing credit crunch.
They also reckoned lower rates would weaken the US currency and prop up the price of dollar-denominated commodities like oil. And investors bet the credit crisis would simmer for a long time, to the detriment of banks and brokerages.
The bet was dead-on - crude more doubled from last August as it hit a lifetime high of $147.90 two weeks ago and banking shares such as Citigroup and Merrill Lynch tumbled 70 percent.
"A lot of the buying that we had seen from late August and until early September was all predicated on Ben Bernanke's 'new transparency,' basically telling everyone he would cut interest rates early and often," said Peter Beutel, president of trading consultancy Cameron Hanover in New Canaan, Connecticut.
The trade seemed linked, like a seesaw; when oil surged, banking shares fell. But two events - one affecting oil and the other banks - have come to the fore to snap the popular trade.
CRACKS APPEAR:
The first crack appeared after US government data began to show demand for energy was waning, a clear warning that oil prices could not climb forever. Then on Sunday, July 13, the Treasury Department and the Fed moved to shore up Fannie Mae and Freddie Mac in a series of proposals to rescue the two struggling mortgage finance companies.
The trade started to unravel later that week after the Securities and Exchange Commission cracked down on short selling in financial shares, causing bank stocks to soar. An unexpected jump in US crude supplies also caused oil prices to fall sharply, forcing traders to reverse bets that oil prices would rise further.
The KBW Bank Index soared 17.3 percent, by far the biggest single-day gain since it was launched in May 1992. Brian Gendreau, an investment strategist for ING Investment Management Americas in New York, said the trade got "killed."
A reversal of the trade has accelerated the recent surge in financial shares and the decline in oil prices, even in the face of some dismal bank results this week. "A lot of hedge funds, particularly those involved in short trading, had the long-oil/short-financials trade for some time," said Rick Meckler, president of hedge fund LibertyView Capital Management in Jersey City, New Jersey.
"So once that trade started to reverse, it has provided particularly strong support even to banks that have had weak quarterly results," he added. Crude prices have shed nearly 15 percent since the price for a barrel of oil peaked while the KBW Bank Index of mostly big US banks has shot up more than 45 percent after sliding to a multi-decade low.
The about-face can be seen in the amount of open interest in crude oil futures, which has tumbled to its lowest level since January 2, 2007. Open interest refers to contracts that have not been exercised, closed out or allowed to expire. Open interest for all oil futures contracts on the New York Mercantile Exchange fell to 1.217 million on Tuesday, down from 1.36 million contracts on July 11, when crude hit its all-time high.
The drop came as prices for September crude settled down $3.98 at $124.44 a barrel on Wednesday, amid growing indications high fuel prices are driving down US demand. "It is a sure sign of long liquidation, certainly the unwinding of length is pretty obvious," said Mike Fitzpatrick, vice president of energy risk management for MF Global.
Hedge funds have aggressively driven oil's rise this year, but institutional investors have gone in the opposite direction, taking profits on equity stakes in energy when prices surged, said Saul Henry, head of US equity strategy at State Street Global Markets.
But in recent weeks, both hedge funds and institutional investors have seemed to anticipate the trend of higher oil prices and sliding bank stocks would reach a limit. In the six weeks through last week, "hedge funds have not been very aggressively putting those shorts back on in financials," said Henry, who pores over $14 trillion in trading volume at State Street to analyse the market.
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