Hedge funds keep markets volatile: Fears over interest rates and inflation cause heavily geared investors to retrench

STOCK MARKET traders made their way back to work after the long Easter break expecting a hectic day. They were not disappointed. The FT-SE 100 index swung through 70 points. One trader described the market as 'casinoesque', but by the standards of recent months it was nothing out of the ordinary.

Just before the holiday, Nick Knight, the maverick strategist at Nomura Research, had drawn parallels with the crash of 1987. He had predicted that the FT-SE 100 would swiftly collapse from around 3,100 to 2,800. The catalyst would be a sharp fall in the US market's Dow Jones average from 3,600 to 3,200.

The suspense grew on Good Friday, when the US Department of Labor announced the biggest monthly employment rise since October 1987 and the benchmark 30-year long bond dropped sharply. The equity markets were widely expected to follow when they opened in the US on Monday and here on Tuesday.

But then it was also April Fool's Day. New York stocks fell 1.2 per cent on Monday, only to snap back 2.3 per cent on Tuesday. London finished up 1 per cent, after a volatile day.

London's traders have grown to accept days like this as the norm. Share prices are at their most erratic since the dark days of September 1992, when sterling was forced out of the European exchange rate mechanism. The reasons appear to be as much structural as sentiment-driven.

Some stockbrokers blame derivatives trading for wild swings. One senior trader said: 'One minute you are 30 points up, the next you are 30 points down. What looks like a good position in the morning becomes a headache in the afternoon. It's strange because there's not much underlying volume.'.

So far this year, the FT-SE 100 has dropped 11.1 per cent from its high - more than any other leading world stock market. But the real crash has been at the long end of the bond market. The FTA British Government Long Bond Index is 12 per cent off so far this year. The trigger was the 0.25 per cent rise in the US Fed Funds rate of 4 February, which signalled the end of the cycle of falling interest rates worldwide. It also gave notice that the liquidity boom fuelled by low US interest rates was over.

A big factor in the plunge in European bond markets appears to have been the giant US hedge funds. They have been borrowing money in the US at about 4 per cent to invest in European bond markets that were yielding about 6 per cent. While established wisdom was that European interest rates were set to fall and bond prices to rise, this seemed a one-way bet.

Hedge funds were joined by the other highly leveraged investors: the banks' proprietary trading desks.

According to Sushil Wadhwani, director of equity strategy at Goldman Sachs International, the increased importance of the hedge funds and other geared investors has largely been responsible for the volatility.

'I think the new factor was that the proprietary trading departments plus hedge funds are much bigger than they have been in the past,' he said.

'A lot of these guys have rigid stop-loss selling when the market falls a certain amount. What that means is that on the bad news you get selling and on the good news you get short covering.

'The volatility becomes self-feeding. Then the volatility per se scares the real money, which becomes more nervous about their views on the fundamentals and so they do not buy on weakness as much as they normally would, which means that the market is more volatile than normal.'

Hedge funds and proprietary traders have used leverage by either borrowing money from banks or trading derivatives. If you put up pounds 1 and borrow pounds 9 and the market doubles you make pounds 10. If the market falls by just 10 per cent you lose everything.

Now these geared players are deleveraging. Research by the US group International Strategy & Investment shows that US banks' securities loans have expanded by more than 25 per cent during the last year. Recently, however, they have started to fall back.

Marcus Grubb, global equity strategist at Salomon Brothers International, has another villain. He says that investment into US mutual funds is slowing as markets become more volatile.

Cash is becoming more tempting as US interest rates rise, and many novice investors are likely to sell if they lose money through falling markets.

Investment Company Institute statistics show that investment in US mutual funds has been running at about dollars 5bn ( pounds 3.4bn) a month, with up to dollars 3bn of that destined for international markets. But figures for March illustrate a startling decline. Only about dollars 1.8bn flowed into US mutual funds, of which only dollars 340m went into international markets.

While it might seem ironic that London's stock market has been worst hit, Mr Grubb sees some logic in it.

Investors have begun to question the old golden scenario of 2-3 per cent inflation. Instead, some fear that inflation is heading up towards 5-6 per cent once more.

He contends that Britain has a history of being prone to relatively high inflation. In addition, it is second to the US in the economic cycle and, therefore, likely to fall victim to inflationary forces sooner than other countries.

These fears are reflected in the price of the short sterling futures contract, which suggests that UK base rates will be 0.25 points higher at 5.5 per cent by July, and will be up to 7.5 per cent by the middle of next year.

Roger Barker, equity strategist at UBS, says volatility will continue until professional investors decide what sort of world we are in and where inflation and interest rates are heading.

But it should at least subside somewhat as hedge funds and proprietary traders deleverage.

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