Fed Policy Risks, Hedge Funds and Brad DeLong’s Whale of a Tale
I have to say it was disappointing to see Brad DeLong’s latest defense of Fed policy, which was published this past weekend and trumpeted far and wide by like-minded bloggers.
For those who missed it, the article is titled: “Bernanke the Washington Super-Whale, Hedge Fundies and the Widowmaker.” This made it sound like a fictional childrens’ picture book, and if that’s what you were expecting, it failed to deliver only on the pictures (there was just one).
Here’s the fictional tale that DeLong weaves:
- “Smart” hedge fund managers shorted the Treasury market in 2008, believing that fundamental value for the 10-year yield was “probably” around 7%. They reacted to their losses in recent years with “larger and larger and larger short positions.” Fund managers blame Ben Bernanke for these losses and are appealing to a higher authority to bail them out.
- These same hedge funds suffered growing losses in 2012 by being on the other side of JP Morgan’s London Whale trades, and they were only rescued in that instance when they pressured JPM’s management to unwind its positions. (This second part is actually at the beginning of DeLong’s article and just a teaser of his approach. I won’t discuss it here, except to note the small problem that it’s impossible for both sides of the same trade to watch their mark-to-market losses grow month after month and right up until the unwind, as described by DeLong.)
And here are a few of the children in his audience, listed alongside their tweets or blog posts announcing the article:
- Josh Barro – “Everyone read this terrific @delong post on why hedge funders hate BenBernanke”
- Mark Thoma – “Learn why hedge fund traders are so angry with Ben Bernanke”
- Justin Wolfers – “Why hedge funds hate Ben Bernanke, and why we should ignore their self-interest whining.”
It’s amazing what people can trick themselves into believing and even shout about when you tell them exactly what they want to hear.
If you take DeLong’s word for it, you would think that the only policy risk that concerns hedge fund managers is a return to full employment. He suggests that these managers criticize existing policy only because they’ve made bad bets that are losing money, while they naively expect the Fed’s “political masters” to bail them out.
Now, I can’t claim to speak for hedge fund managers as a class any more than DeLong can. But I do read and listen to what many of them have to say, including the three “Bernanke-haters” cited by DeLong in a later post: Stanley Druckenmiller (of Quantum Fund and Duquesne Capital fame and now retired), Kyle Bass (Hayman Capital) and Paul Singer (Elliot Capital). Many other managers have also questioned Fed policies, as have a whole bunch of folks in the traditional asset management space, such as Jeremy Grantham and Bill Gross.
Are these professional investors really just concerned about a return to full employment? Are they just protecting their positions? Were they bamboozled by the Treasury market rally?
Well, every one of these claims is blatantly false. DeLong’s story is irresponsible and arrogant, really. And since he flouts the truth in his worst articles and ignores half the picture in much of the rest, I’ll take a stab here at a more balanced summary of the pros and cons of the Fed’s current policies. I’ll try to capture the discussion that’s occurring within the investment community that DeLong ridicules.
Benefits and risks of extreme monetary stimulus
Firstly, the benefits of existing policies are well understood. Monetary stimulus has certainly contributed to the meager growth of recent years. And jobs that are preserved in the near-term have helped to mitigate the rise in long-term unemployment, which can weigh on the economy for years to come. These are the primary benefits of monetary stimulus, and I don’t recall any hedge fund managers disputing them.
But the ultimate success or failure of today’s policies won’t be determined by these benefits alone – there are many delayed effects and unintended consequences. I’ll describe seven long-term risks that aren’t mentioned in DeLong’s article, replacing his made-up world with messages from professional investors (h/t ZeroHedge for many of the links).
Risk #1 – Inequality and social injustice. The Fed’s current stance continues an entrenched pattern of public policies that favor the wealthy, in general, and bankers, in particular. I’ve always been puzzled as to why DeLong and other economists who revere John Maynard Keynes are so often silent on this basic issue of fairness. Keynes called for policies to lower interest rates and squeeze out the “rentier” class – those who live off their wealth. But today’s situation is totally different to the interwar period during which Keynes produced his most famous work. The effects of interest rate changes on the distribution of wealth have completely reversed.
Wealthy classes are best characterized today as risk-takers and have profited immensely from both low rates and QE. But we now have a vast middle class that relies on adequate bond yields to fund retirement. And current policies are disastrous for these middle class retirees (and near retirees). If Keynes were alive today, he would have surely adjusted his message to account for the fact that low rates are no longer an egalitarian policy. His followers, on the other hand, seem happy to stick to the old script.
And not only do recent policies have insidious social effects, but they also have dangerous economic effects. Lawrence Fuller of Fuller Asset Management recently discussed these effects and summarized them like this: “The real economy is horrid for the vast majority of Americans. The Fed’s deluge of credit has disproportionately benefited those who didn’t need assistance in the first place. As a result, the cracks in the foundation of our economy are beginning to show up in the macro-economic data.”
Risk #2 – Banking crises. Did DeLong consider the impetus for JP Morgan’s London Whale trades before writing his article? If so, he would have recognized that funding costs for JPM’s CIO office (where the Whale worked) are at record lows, thanks to the Fed. Moreover, JPM knows from its Bernanke (and Greenspan) experiences that whenever anything goes wrong in the financial sector, the Fed saves the day.
These facts surely had something to do with Jamie Dimon’s encouragement of hugely risky bets in credit derivatives, which showed that the last decade’s excessive risk-taking remains alive and well. And as long as risk-taking persists, so does the possibility of a brand new crisis. There’s more than a little irony in DeLong’s decision to link JPM’s ill-fated derivatives bets to his defense of monetary policy. Presumably, it was unintentional.
What’s more, it’s possible that the next banking crisis will be more sudden and damaging than the last, especially as a portion of the private sector’s leverage has been transferred to the public sector rather than being extinguished. Paul Singer links the risk of a more severe crisis to the lessons learned in 2008, Dodd-Frank provisions that reward creditors who bail out early, and the continued impossibility of extracting accurate risk information from bank balance sheets. Here’s an excerpt from a speech that Singer delivered last year:
… if you are observing a large company getting into trouble, what you know is that you have to pull your assets because those assets can be transferred … You don’t know how your claim will be treated, so you have to sell the bonds that you own … So the whole thing militates toward stepping away abruptly from any company that is designated as systemically important. So I think that the opacity, the lessons of ’08, the vicissitudes and thoughtlessness of Dodd-Frank, militate in favor of a very, very abrupt resolution.
Risk #3 – Public debt-related risks. Skyrocketing public debt can have a variety of unwelcome consequences, contrary to what you may hear from exuberant Reinhart-Rogoff smear campaigners, whom I wrote about here and here. Nor will you hear about these unwanted effects from DeLong, who ignores fiscal policy risks just as studiously as he ignores monetary policy risks. His academic work on fiscal policy is based on the assumptions that debt can rise without limit (trillions, quadrillions, quintillions, you name the number and it’s achievable according to DeLong’s model) and stimulus can be applied without ever needing to counterbalance it later with restraint. (Read here for more detail.)
The connection to monetary policy is that there’s little incentive today for politicians to take serious action on the debt. In the current political calculus, deficits don’t matter as long as they can be funded for a pittance, and Fed policies have reduced funding costs to exactly that – a pittance. Kyle Bass said it clearly last year, noting that when he challenges congressional leaders on their poor fiscal habits, they tell him to look at the 10-year.
People may forget that we once had a central bank that fought hard for fiscal discipline. While he was busy crushing inflation and ushering in a multi-decade period of stability, Fed Chairman Paul Volcker essentially told Congress and the Reagan Administration (while publicly denying it): No deficit reduction, no changes in monetary policy.
Consider these accounts from William Greider’s Secrets of the Temple:
Reagan’s OMB Director David Stockman: “Volcker was telling everyone, ‘If you give us some relief on the deficits, it will take some pressure off … Our hands are tied unless you give us some relief on the fiscal side.”
Influential Congressman and Reagan tax cut champion Jack Kemp: “Monetary policy is deliberately being kept unnecessarily tight and the economic expansion held hostage to a tax increase … Mr. Volcker would offer a quid pro quo of monetary ease and lower interest rates in return for a fiscal policy of higher taxes which is more to his liking.”
Notably, these discussions occurred during and after a deep recession. But Bernanke’s Fed has chosen to abet rather than limit our soaring national debt, rejecting Volcker’s approach. Bernanke’s methods lessen the immediate debt burden, while likely increasing the costs that we’ll have to bear in the future. And history has shown again and again that these costs can be devastating.
Risk #4 – Extreme economic volatility. It shouldn’t be surprising that the investment community is intently focused on the eventual “exit” from extreme monetary stimulus. Just as history has proven the risks of excessive public debt, it also shows that bad things tend to happen when policy swings from stimulus to restraint. When you remove stimulus, expansions have been more likely to end than continue, as I showed here.
In the case of monetary stimulus, the Fed could eventually find itself between a rock and a hard place. Zero interest rates and strong growth aren’t compatible with the price stability portion of its mandate, whereas rising rates usually tip economies back into recession. At some point in the future, the Fed may be confronted with only those two options. And the longer it chooses to “beat a donkey (a 1% growing economy) for not being a horse (a 3% growing economy),” to quote Jeremy Grantham, the likelihood of such a lose-lose scenario increases.
Grantham’s grasp of economic reality contrasts sharply with DeLong’s advice, which is rooted in recession-free economic projections such as those of the Congressional Budget Office (CBO). DeLong’s approach helps to preserve a long academic tradition of ignoring the economy’s natural cyclicality, assuming instead that economies revert to a “full employment equilibrium” and then stay there. With this assumption, the case for stimulus during recessions is usually stronger than it would otherwise be. But unfortunately, such a world doesn’t exist outside the economics profession.
Risk #5 – Credit crises. When you choose to fight a debt crisis with more debt, insolvency risks are unlikely to normalize for very long. And if these risks aren’t priced properly because, say, markets are manipulated by public officials, a fresh crisis could be closer than you may have thought. This was essentially the threat discussed in February in a speech by Fed Governor Jeremy Stein, who created a stir with his analysis of incipient credit risks. DeLong makes a cryptic reference to Stein in his whale of a tale article, perhaps to hint that he doesn’t share Stein’s concerns. If that’s indeed the case, DeLong must have decided that insolvency risks are too insignificant to discuss.
What could possibly go wrong with such complacency?
To pick just two sectors: Does he realize that today’s volumes and delinquency rates for student loans aren’t that different to the figures for sub-prime bonds as of 2006/07? Has he looked at the high yield bond risks discussed by Stein, especially as the Barclay’s high yield index shattered records this month by yielding less than 5%? As far as I can tell, DeLong’s analysis extends no deeper than his cryptic references (if I’m wrong about this, please send me the research), and these aren’t especially helpful.
Risk #6 – Asset price bubbles. One way to approach asset valuation is to break it into three pieces:
- What are the expected cash flows?
- How much are you paying for those cash flows?
- How does the IRR implied by #1 and #2 compare to an appropriate benchmark interest rate?
Applying this approach to U.S. stocks, the market peak in 2000 was explained mostly by changing perceptions about question #2 – investors finally accepted that they were paying too much. The peak in 2007 was explained mostly by changing perceptions about question #1 – investors were reminded that corporate earnings tend to mean revert (with especially big adjustments in the financial sector). At the next peak, we may find that changes in the answer to question #3 are the driving force. The trigger would be an increase in benchmark interest rates.
In fact, this risk is baked into the Fed’s argument that its policies stimulate the economy through the portfolio balance channel – their jargon for buying so much of a few assets (Treasuries and mortgages, in this instance) that you push up the prices of all assets. It goes without saying that the portfolio balance channel works in both directions. When the benchmark assets turn around, so does everything else. Stanley Druckenmiller memorably described these asset pricing risks in a recent interview with an incredulous expression and this pair of rhetorical questions:
The thought that you can exit by wherever the balance sheet will be at that time – $4 trillion or wherever it is – in an orderly manner … Do you know what guys like me are going to do when they sell the first bond out of $4 trillion? And don’t think that letting the bonds run off isn’t selling. That debt has to be refinanced. If you just let all the bonds run off, that is still $4 trillion in selling … What do you think the markets are going to do when they figure out the exit?
And by the way, projected cash flows and prices (questions #1 and #2 above) are also showing some signs of froth. Maybe in the same way that froth was apparent in 1997 or 2006, several years before the respective peaks, but froth nonetheless.
Risk #7 – Real economy distortions. You’ll rarely find Keynesian economists such as DeLong discussing the unintended effects of public policies on private decision-making. But just like the other risks listed above, these effects should never be glossed over. In the case of the Fed’s extreme stimulus, one of the most obvious consequences is that business people are incented to exploit artificially low interest rates through purely financial strategies. These are typically short-term strategies that lock in a yield difference.
On the other hand, the Fed may be discouraging capital spending on tangible, long-term investments. Unlike many yield-based strategies, capital spending decisions are subject to the additional uncertainties of the eventual exit from extreme stimulus. Bloggers popular in the investment community, such as Tyler Durden, have long written about this risk. Here are Bill Gross’s thoughts, lifted from a client letter that was published on ZeroHedge in January:
Zero-bound interest rates, QE maneuvering, and “essentially costless” check writing destroy financial business models and stunt investment decisions which offer increasingly lower ROIs and ROEs. Purchases of “paper” shares as opposed to investments in tangible productive investment assets become the likely preferred corporate choice. Those purchases may be initially supportive of stock prices but ultimately constraining of true wealth creation and real economic growth. At some future point, risk assets – stocks, corporate and high yield bonds – must recognize the difference. Bernanke’s dreams of economic revival, which would then lead to the day that investors can earn higher returns, may be an unattainable theoretical hope, in contrast to a future reality.
Spotting the real villain in DeLong’s article
Getting back to DeLong’s article, his “Bernanke-haters” really don’t have to share their fiscal and monetary policy concerns with the general public. They certainly haven’t done this out of frustration with losing trades. At least two of the three managers whom he cites (in the separate post that refers to Druckenmiller, Bass and Singer) have been on the record with accurate predictions that Fed-fueled market rallies were likely to continue for some time. DeLong’s claim that these managers have probably “spent years shorting Treasuries” is preposterous.
The real reason that we hear from these hedge fund managers is their exceptional track records. The media realizes that they’ve shown a remarkable understanding of economic risks, and therefore, their opinions are widely reported. They haven’t necessarily sought an audience, but they’ve certainly earned one.
DeLong, on the other hand, epitomizes an academic community that regularly gets blindsided by real life events. It’s a shame that they claim authority on economic issues, because we all suffer when their abstract theories blow up in their faces as happens time and again. This is yet another reason that we should call foul when we see an irresponsible piece of fantasy like DeLong’s article.
Now sure, I can understand why he wrote it the way that he did. Is there a better way to fire up your acolytes than by wrapping a clever little rant around a popular villain? According to DeLong’s crowd, hedge funds are about as villainous as they come. And this crowd was beside itself with glee as they spread the word about the whale of a tale. Check out the tweets noted above and you’ll see that the comments following them were full of giddy, backslapping fun and many happy contributions from DeLong himself.
But to me, the shoddy quality of DeLong’s work buries his wit. It’s nice to have camaraderie, but we all know that people are capable of some pretty ugly camaraderie.
In my opinion, DeLong and his joyful followers are once again behaving like a pack of fools. And he once again made a mockery of the header for his website. Beneath the simple title, “Brad DeLong,” his tagline reads “Grasping Reality with Both Invisible Hands: Fair, Balanced, and Reality-based.”
As I said, DeLong may have been grasping for some Twitter love with his whale of a tale, but he certainly wasn’t delivering reality, fairness or balance.Courtesy: Cyniconomics
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