Are Hedge Funds Chasing or Shunning Risk?

To say that the markets have been volatile as of late is an understatement.

There are news triggers popping up every day about the potential default of the United States government, which isn’t inspiring confidence, to say the least.

Congress can’t agree on whether to raise the debt ceiling, which is another disaster in the making.

If they don’t, it will be a disaster in the short term. If they do, it will be a disaster in the long term—but that’s another story.

There is also speculation that the next big earthquake is about to hit California, that radiation levels from Japan are penetrating the atmosphere and drifting across the world and are into the food supply, and that the beginning of World War Three is upon us.

As investors, we need to know how these events impact the risk appetite for the world’s hedge funds.

For example, if the risk appetite is high, then most asset classes are going to rise.

However, if risk appetite is low, then most assets will fall in price.

In other words, the news actually isn’t that important. What’s important is how these hedge funds respond to the news.

Wouldn’t it be nice to know when the hedge funds are feeling risk adverse so we would know when they are about to dump assets?

There is a tool for doing this. It’s called the Australian Dollar/Japanese Yen Currency Cross, better known as AUDJPY.

This chart, although not the sole barometer of money flows across the world, is the best indicator out there of what the big hedge funds are doing.

To put it simply, if AUDJPY is moving higher, hedge funds are borrowing low cost currency such as Yen, and putting it into higher yielding assets such as Australian Dollars, and using margin against those assets to buy things like gold, silver and stocks. And as long as AUDJPY holds steady or moves higher, this is what’s going on around the world.

During times when the AUDJPY is moving higher, we aren’t going to see any major sell offs in the major asset classes. What’s interesting about this is that hedge funds are longer term in nature and won’t run at the first sign of bad news.

In other words, what might be interpreted as bad news in the financial press could be shrugged off by hedge funds. And this would be indicated by an AUDJPY price that is holding steady.

But what if AUDJPY starts to fall?

What does this mean?

It means that risk is suddenly shunned  Positions are unwound. Assets bought on leverage are sold, and Yen that was borrowed is paid back.

By watching the chart of AUDJPY, we get a feel of money flow into and out of the world’s major asset classes.

Rather than discuss and debate if stocks are overbought or oversold right now, just look at AUDJPY. This is a simplified version of things of course but the idea is key – if AUDJPY is selling off, it’s a margin call on the world and assets must be sold to meet that margin call.

Let’s look at the big drop in 2008.  It coincided with the financial crisis, and was essentially one of the biggest margin calls the world has even seen. This move down in stocks was led by a move down in AUDJPY, which told us that hedge funds were taking risk off the table—which meant that large hedge funds were moving out of risk and into safer assets such as bonds.

Rather than guess how the markets are going to react longer term to bad news, I prefer to just watch the quotes on AUDJPY.

In July 2011, it currently has a range between 87.50 on the upside and 83.50 on the downside. If we break through 87.50 on the upside, look for stock markets around the world to rally. If we break through 83.50 on the downside, then it’s time to get out of stocks as the selling is going to be severe.

It’s all about money flows and whether risk is being put on or being taken off…

And AUDJPY tells us exactly that.

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