Hedge funds learn the hard way in bond shock
Few people will shed a tear for the hardships of all of Mayfair, and neither should they. In recent times, many macro hedge fund managers looking to profit from major economic and monetary changes have experienced what can politely be described as a complete nightmare.
To the immense fun from the creators of online memes, some of the industry’s most prestigious funds have bet big on the outlook for global interest rates and have lost a lot. Adding insult to injury, much of the damage came from paltry UK government bonds – a crucial pillar of the UK financial system but not exactly the glamorous end of the global debt market.
The episode is peppered with exasperated traders, multibillion dollar losses and frustration that the Bank of England has the audacity to torpedo bets on very serious bonds. If anyone wants to do this, it should be the Fed, surely? The European Central Bank in suspense. (As one American investor told us this week: “No offense to our British friends …
Behind the broken egos and schadenfreude, however, lies a serious message for investors of all types. In short, it is wise to get attached.
First, a quick recap of what went wrong. One element is that betting on a change in the global interest rate environment is extremely popular, and investors often choose hedge funds to do this big job for them. âClients are more interested in hedge funds than they have been in the past four years,â says Peter van Dooijeweert, Managing Director of Man Solutions at Man Group.
These funds don’t really exist to take stilted and boring positions. Instead, investors want them to be bold, and they are. âCustomers want volatility,â says van Dooijeweert. âYou hire them to make you 40 percent. This means that they will have rainy days. Ideally not a deluge that floods the basement, but rainy days.
The Kremlinology of extracting meaning from central bankers’ statements is an essential way for funds to do so – a highly specialized sport of reading between the lines.
Alan Greenspan, Chairman of the Federal Reserve from 1987 to 2006, was like a sphinx in his comments. As he once remarked: “I know you think you understand what you thought I said, but I’m not sure you realize what you heard is not. what I wanted to say.
Jean-Claude Trichet, President of the ECB from 2003 to 2011, operated a code word policy system. Euro traders and others judged the likelihood of an interest rate hike depending on whether he said inflation deserved “vigilance”, “strong vigilance” or, if he was. really worried, a “very strong vigilance”.
Some central bankers are better at “talking about the markets” than others. Mario Draghi, President of the ECB during the end of the Greek debt crisis, was he maestro of this art, pushing the euro or European government bond yields higher or lower as desired by knowing references to obscure financial indicators.
Traders felt they knew him and trusted him, so when he said in the summer of 2012 that the ECB would do “whatever it takes” to preserve the euro, they knew he really meant it. No details required; those three little words were enough to stabilize the region’s bond market as a whole.
His successor, Christine Lagarde, has discovered the hard way that slippages can be costly. During one of her first press conferences in her leadership role, she suggested that it was not the ECB’s job to control the bond market. Report a nasty drop in Italian government bonds and a quick apology.
This brings us to Andrew Bailey, Governor of the BoE, grappling with the undoubtedly delicate task of trying to explain what the central bank might or might not do in response to a global spike in inflation. Bailey had previously signaled growing unease over inflation, but in mid-October he spoke up, saying “we will have to act”.
Of course, there were caveats, ifs, and buts, and the clues are not promises. Still, it threw the gilts into a gamble on impending rate hikes, putting the bets on greater patience thanks to the chipper. The punchline: The BoE ended up holding back fire at its rate-setting meeting a few days later.
This matters beyond the crowd of quilted jackets and hedge fund boat shoes for several reasons. One is that the shockwaves that have emanated from the gilts (and arguably Australian government bonds) market to Treasuries and Bunds are a reminder of how interconnected the financial system is.
Another is that while central bankers often say they’re not there to help hedge funds make money, market participants often don’t believe them. It shows that they should do it.
Quite clearly, the global financial system has done very well. Policymakers don’t try to shake the markets just for fun, but until financial stability is compromised, that’s not really their problem. This could prove to be an important point as central banks gradually withdraw their support – an almost guaranteed process to inject volatility. Investors who truly believe that policymakers will step in quickly to stop any market decay may want to think again.