June 2, 2013 7:38 pm
Hedge funds: Fighting the Fed
Investors have launched attacks on Ben Bernanke
Paul Singer does not like the US Federal Reserve. Nor is he shy about sharing his opinions on the Fed, its policies or its chairman.
Mr Singer, who runs the $22bn Elliott Management hedge fund, has called Fed policy makers “frantically flailing, over-educated, posturing bureaucrats engaged in ever more astounding experiments in monetary extremism”.
In a 2011 polemic to his investors, he described the commentary of Ben Bernanke, the Fed chairman, as “more like careless talk-radio rants” than prudent statements appropriate to the guardian of the US dollar. Until the Fed allows interest rates to rise, “capital will continue to be misallocated throughout the economy, real investment ‘risk’ will be almost impossible to determine and a firm foundation for solid growth in the American economy cannot be created.”
Signs of a strengthening US recovery have not blunted his attacks, nor has a bull market in equities. At a recent conference in New York he warned that confidence in so-called “fiat currencies” would soon collapse.
Taken alone, these comments might be dismissed as jeering from the sidelines by an eccentric billionaire. Mr Singer, a specialist in distressed investing, is famously combative, having made international headlines for waging a long-running battle with the government of Argentina.
But it would be a mistake to suggest that Mr Singer is a lone voice in the hedge fund industry, which has become the source of some of the most searing attacks on the Fed and its post-crisis policies.
No less than Stanley Druckenmiller, who over three decades of trading currencies and interest rates became one of the most successful hedge fund managers of all time, has joined in. Mr Druckenmiller says Mr Bernanke “is running the most inappropriate monetary policies in the history of the free world”.
His concern is not the risk of inflation, which has prompted investors such as Mr Singer and John Paulson to load up on gold. Instead, it is a broader concern that has been voiced by growing numbers of the most powerful and influential professional investors: that by pushing down interest rates and buying up government bonds, the Fed is warping the norms of economic behaviour.
Modern finance is built on the concept of using the cost of government debt as a yardstick for value, particularly the super-safe debt of the US government. A change in its price affects what people are willing to pay for everything from stocks and bonds to office buildings and homes. Mr Druckenmiller says that the Fed’s programme of buying US Treasuries and other bonds – the bedrock of its quantitative easing policies – is “controlling the most important Price in the US economy”.
The low rates that result from the Fed’s bond buying make previously uneconomic decisions viable – leading to dangerous distortions in the market, critics say.
David Einhorn, founder of Greenlight Capital, last year likened Fed policies to jelly doughnuts, suggesting that the markets were being force-fed a steady diet of sugar by policy makers who do not have a decent handle on how capitalism works. Fed officials, he said, “do not understand greed [and] they also do not understand fear, which presents a double whammy for making bad policy decisions.”
. . .
There is one man at the Fed who certainly does understand greed and fear, and can see a bit of himself in these market operators. From 1987 to 1997 – a decade of crash and then boom – Richard Fisher ran his own asset management firm.
Mr Fisher is now president of the Federal Reserve Bank of Dallas. He opposed “QE3” – the third round of Fed bond-buying, currently running at $85bn a month – for many of the same reasons as the hedge fund managers. But his critique is tempered by a keen understanding of the hedge fund managers’ motives, as well as the rationale for the policy.
“There are very few client bases in the hedge business that are tolerant. They want you to put money to work,” he said in an interview with the Financial Times.
When asset prices are shooting higher, that becomes painfully hard to do. “Part of the pressure comes from knowing, or sensing, that at some point you are going to get a reversal,” Mr Fisher says. “If I was in my old business I’d be looking around [asking] how am I going to make money without taking undue risk?”
It is a big problem for the masters of the universe. They live for distortions in markets, which provide them with opportunities to throw billions of dollars at a brilliant trade that will push prices back in line with reality. Successful hedge fund managers make their reputations by being clever, brave or fast enough to seize on these chances.
Two decades ago Mr Druckenmiller and George Soros placed billions of dollars worth of bets that the UK government would not stomach the high interest rates needed to maintain the value of sterling against the Deutschemark. They were right, and their triumph marked the beginning of an era that saw hedge fund managers as gunslingers, feared by governments.
Yet they now find themselves outgunned. “Fighting the Fed” – rarely a good idea for anyone – has proved fruitless for them, and markets have moved for the past four years in response to the actions of policy makers, not what investors refer to as the underlying “fundamentals”.
And so the gunslingers are now left to issue dire warnings, and even to decry the immorality of Fed policies. Seth Klarman, another specialist in distressed investing, says he is worried about the effect of low interest rates on retirees and savers. “We must question the morality of Fed programmes that trick people (as if they were Pavlov’s dogs) into behaviours that are adverse to their own long-term best interest,” Mr Klarman wrote in a letter to investors in Baupost, his $27bn hedge fund.
“What kind of entity drives the return on retirees’ savings to zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should play this large a role in the economy,” Mr Klarman says.
Yet savers are also customers of hedge funds – who count on pension funds for business these days – and so lower returns for savers also mean lower profits for professional investors. According to HFR, a research group, the average hedge fund has produced average after-fee returns for its investors of just 2.5 per cent a year over the past five years.
By comparison, in the decade before the financial crisis, the average hedge fund produced investment profits for its investors of more than 10 per cent a year. For businesses that typically take a 2 per cent annual management fee and then 20 per cent of any profits they make with their clients’ money, persistent low rates are a challenge.
After five years, the criticisms made by Mr Singer and Mr Druckenmiller are monotonously familiar to policy makers at the Fed, and they largely miss the point. Mr Bernanke has never been shy about the case for buying assets or the effect it is supposed to have. If the Fed buys Treasuries and mortgage securities, there are fewer of them around for private investors to buy. Interest rates fall as a result, stimulating the economy.
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending,” Mr Bernanke wrote in 2010. For the Fed, higher stock prices after QE3 are like weight gain after eating: it is just what happens. With investment low and workers idle following the recession, the economy was malnourished and needed a few extra pounds.
From the Fed’s point of view, lack of demand is the true distortion in the US economy, and one it is trying to fix. As for Mr Druckenmiller’s charge that it is “controlling the most important price in the US economy”, the Fed could put that on its letterhead. It is pretty much a mission statement.
. . .
There is a strand of the hedge fund critique that does resonate at the Fed, however, because if one thing has changed at the institution in the past nine months it is the perception of QE3’s risks to financial stability.
For three decades interest rates have largely moved downwards. But now, with yields at or near record lows for all sorts of fixed income assets, the round of QE3 bond buying has been like the Fed compressing a spring. It is now down as far as it is easily possible to go.
Investors know that at some point the Fed will step away, but they can only guess when it will happen and what the consequences of a rebound in yields will be. Mr Klarman has warned his investors of the consequences. “The rush to the exits will be madness, as today’s clarity will have dissolved, leaving only great uncertainty and probably significant losses.”
The hedge fund manager’s spider sense – that tingle at the base of the skull that tells them to worry about the market – is also sending signals on the second floor of the Federal Reserve.
At the Jackson Hole retreat for central bankers in Wyoming last summer, when the Fed was gearing up for QE3, Mr Bernanke discounted the danger of bubbles. “We have seen little evidence thus far of unsafe build-ups of risk or leverage,” he said.
But in a widely noted speech this February, Jeremy Stein, a new member of the Fed’s board of governors and a finance professor at Harvard, said there is now a “fairly significant pattern of reaching-for-yield behaviour” in corporate credit.
Concerns about financial stability have not persuaded the Fed to change course – QE3 continues – but perceptions of its cost are rising with the size of the Fed’s balance sheet. There is an active discussion about when to taper the purchases down from $85bn a month.
Mr Fisher says that he gives Mr Bernanke credit for putting financial stability at the heart of the Fed’s deliberations. For his part, Mr Fisher would like to taper the programme off, and he is adamant that a bad market reaction should not stay the Fed’s hand if it thinks that is the right move for the economy.
“In the best of all worlds you have a period of slow but positive returns. But my experience is that markets overshoot on both sides,” he says. “What I worry about is the Little guy who gets sucked in at the end. That has a social consequence.”
. . .
QE: ‘The Fed has lost some of its independence’
Not all masters of the universe have harsh words for the Federal Reserve, writes Dan McCrum.
What criticism he has is more measured, and is of the type that sees the Fed less as villain and more as enabler of the true scoundrels: the politicians who have made promises that taxpayers are on the hook to keep.
“My concern is that the Fed has lost some of its Independence. The role of the Fed is to be independent from Congress, from the executive branch, so that it is best positioned to make tough decisions. Just as market discipline applies to firms, you want that to apply to the tax-and-spend mentality of the Federal government,” he says.
Investors such as Bill Gross of Pimco, manager of the world’s largest bond fund, as well as hedge fund managers such as Paul Singer and Stanley Druckenmiller, have warned that pension and healthcare promises to future retirees are too large to be kept and may prompt a crisis.
So it is not just investors whose behaviour is distorted by low rates; cheap government borrowing is seen as postponing the day when federal spending commitments might be addressed.
Yet Mr Bernanke has long said that interest rates would remain low regardless of his actions.
In a response to a question last year from Paul Ryan, the former vice-presidential candidate and the House Republican budget leader, Mr Bernanke said: “The basic reason for low long-term rates, which are also a feature of every other major industrial economy, are low inflation, slow expected growth and the fact that the dollar is a safe haven.”
He has elaborated on this argument in several speeches, where he says that if long-term rates were not low because of Fed quantitative easing, they would be low because of very weak growth and inflation instead.
Copyright The Financial Times Limited 2013.
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