FED: The World's Biggest Hedge Fundby Stephen Roach (Morgan Stanley)
The title belongs to America's Federal Reserve. Not only is the Fed the unquestioned leader in world central banking circles, but the US monetary authority has led the way in setting up the biggest macro trades of modern times. Highlights include Carry Trade I of 1993, the equity bubble of the late 1990s, and now Carry Trade II -- all direct outgrowths of trading strategies implicitly recommended by Greenspan & Co. So far, the world is no worse for the wear. But it's a world that now lives from trade to trade. And with that precarious existence comes the ever-present risk of breakage -- the aftershocks that follow the unwinding of every trade. We have the Federal Reserve to thank for that. This transformation began in earnest in 1987. As the US equity market surged toward excess that summer, there was deep conviction that downside risks were not to be feared -- that they would be protected by the options strategies of the perfect hedge, "portfolio insurance." The Crash in October unmasked the flaws in that supposition. The Fed responded to this crisis by offering up the unconditional palliative of an open-ended liquidity backstop. Out of that chaos nearly 17 years ago, the dip-buying mindset of a generation of equity investors was borne. In retrospect, the buying opportunity created by the Crash of 1987 was a bargain that no serious investor -- especially the levered hedge fund community -- could afford to miss.
Five years later, financial markets were offered another learning experience. In response to what Fed Chairman Alan Greenspan dubbed "financial headwinds," the Fed slashed its policy rate to 3% in September 1992 and held it there until February 1994. The Fed believed that an unusually steep yield curve was the appropriate antidote for the credit crunch it thought was hobbling economic activity -- an outcome brought about by America's saving and loan crisis and widespread loan losses in the commercial banking system. With the federal funds rate pushed down to the inflation rate, overnight money was essentially "free" in real terms. For a troubled banking system, this was a great opportunity to re-liquefy balance sheets. For the levered hedge fund community, this was another no-brainer --the only question was where to play the spread. The origins of the modern-day "carry trade" are traceable to this period.
Fast-forward to 2004, and it's déjà vu -- but with several important new twists. First, the financing of the current carry trade is now occurring on much more generous terms; the federal funds rate of 1.25% is fully 200 basis points below the headline CPI inflation rate (3.3% Y-o-Y as of June 2004) -- offering a negative cost of overnight money. The real federal funds rate hasn't been this low for this long since the late 1970s. In effect, levered investors are now being paid to play the yield curve. Second, suffering from a shortfall of income generation in a uniquely jobless recovery, American consumers have turned into the functional equivalent of heavily levered hedge funds -- going deeply into debt to extract purchasing power from their homes (see my 4 June dispatch, "The Mother of All Carry Trades"). Third, the carry trade has now become central to America's twin-deficit financing imperatives; record budget deficits and current account gaps have been funded "painlessly" -- in large part though purchases of dollar-denominated assets by Asian monetary authorities. The yield curve play has turned foreign central banks into hedge funds as well.
The Fed obviously sees its role quite differently. Fixated on inflation control -- yesterday's battle, I must add -- the US central bank pays little heed to excesses that emerge in financial markets. Favoring a reactive over a pro-active approach, the Fed believes it has both the skills and the tools to respond to problems in asset markets as they unfold. In the words of Chairman Greenspan in describing the Fed's conduct as the equity bubble expanded in the late 1990s, "...we chose...to mitigate the fallout when it occurs" (see his January 3, 2004 speech at the Meetings of the American Economics Association, "Risk and Uncertainty in Monetary Policy"). The Fed believes that this approach has been vindicated by the subsequent course of events.
In light of America's surprisingly mild post-bubble recession, Greenspan argued (in this same speech) that it is reasonable "...to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful." Success at what cost? That is really the ultimate question in all this. To the extent that the Federal Reserve continues to set the stage for one risky macro trade after another, I believe there is great peril in its strategy. Last year's deflation scare was a case in point. As disinflation approached the hallowed ground of price stability, nominal interest rates moved down to rock-bottom levels. But as the risk of "unwelcome disinflation" stoked fears of a Japanese-style deflation, the Fed went into a fire drill that pushed its policy rate perilously close to the zero boundary. Yet another carry trade became a sure thing in this climate. As the risk of deflation receded, the debate turned to the Fed's exit strategy -- the so-called normalization of an extraordinary monetary accommodation. By telegraphing that the ensuing shift in policy would be "measured," the US central bank put financial markets on notice that it will be taking its time in raising interest rates.
For those playing the carry trade, time is money. To date, of course, the Fed has taken but one small step in returning its policy rate toward a more neutral setting. This has done next to nothing to discourage the vast array of carry trades that are still on the books in financial markets. Amy Falls, our global fixed income strategist, argues that most of these levered bets are now almost back to positions prevailing before the Fed's late June move. That's especially the case, in the view of our fixed income team, insofar as most spread products are concerned -- namely mortgage-backed securities, high-yield bonds, emerging market debt, and even investment grade paper. Our European equity strategists, Teun Draaisma and Ben Funnell, make a similar point -- that with sharply negative real short-term interest rates, it takes a lot more than 25 bp of monetary tightening to unwind the carry trade (see their July 13 essay, "The Crowded Carry"). They underscore the weakest link in this daisy chain -- that the risks to the levered community are likely to fall most acutely on banks and consumers, where the need for carry-trade-induced income generation is most acute. That pretty much fits with my own concerns, especially with respect to the over-extended American consumer.
What worries me the most in all this are the mounting systemic risks toward carry trades and the asset bubbles they spawn. To the extent that such trading strategies create artificial demand for assets, a seemingly unending string of bubbles is a distinct possibility. That's precisely what's occurred in recent years -- from equities in the late 1990s, to sovereign bonds, a host of spread products, and now possibly to a global housing bubble (see my 15 July dispatch, "Global Property Bubble?" and the accompanying round-up of worldwide housing market conditions conducted by our global economics team). This profusion of carry trades would not have occurred were it not for the Fed's extraordinary degree of monetary accommodation and the steep yield curve it fostered.
It doesn't have to be this way. Both the Bank of England and the Reserve Bank of Australia have adjusted their policies to take property bubbles into explicit consideration. Moreover, Ottmar Issing of the ECB has publicly stressed the need for central banks to do a much better job in grappling with the linkage between monetary policy and asset markets (see his February 18, 2004, editorial feature in the Wall Street Journal, "Money and Credit"). The Fed, by contrast, remains in denial on this key issue -- refusing to concede that monetary policy must take asset inflation into account. Unfortunately, the role of the US central bank goes beyond benign neglect. Over the past several years, the Fed actually has been quite aggressive in arguing why excesses are not bad. That was the case when it repeatedly
justified the equity bubble on the basis of the so-called productivity renaissance of the New Economy. It has also been the case when the Fed has argued that America is not suffering from a debt problem, nor a twin deficit financing constraint. By serving as a cheerleader when financial markets are going to excess, the Fed is losing its credibility as an objective observer. It is no longer the tough guy that relishes the role of "taking away the punchbowl just when the party gets going" -- to paraphrase the legendary mantra of former Fed Chairman William McChesney Martin. By condoning excesses, the Fed, in effect, has become a stakeholder in the carry trades it spawns. Investors, speculators, income-short consumers, and financial intermediaries couldn't ask for more. It's the ultimate moral hazard play that that has turned the world into one gigantic hedge fund.