US Fed Decision: What does it mean for Hedge Funds?



“The world economy is locked on a course towards an emerging markets crisis and a renewed slowdown in the US, regardless of the Federal Reserve holding off on a rise in rates last week. The Fed would eventually be forced into a fourth round of quantitative easing to shore up the economy,” warns John Burbank, the Hedge fund manager who successfully bet against subprime mortgages during the 2007 housing crisis.

Burnbank believes the extraordinary accommodative policy of the Federal Reserve and its forthcoming undoing will cause the next financial disaster, according to an interview with Real Vision, an on-demand video platform for finance.

Hedge Funds bets went wrong

Hedge funds and other speculators were wrong-footed by the decision to keep interest rates near zero. They had taken a big net short position in interest-rate contracts ahead of the FOMC meeting as they were expecting a hawkish path from the Fed. The speculators were expecting to profit had the Federal Reserve lifted interest rates. Their bets proved wrong-footed, leaving traders poised to reverse course at huge loss.

According to the Commodity Futures Trading Commission (CFTC)’s Commitment of Traders (COT) data, two days before the FED meeting, Gold speculators had slashed net bullish positions by 75% and added significantly to short positions -bets that gold could be bought cheaper in the future. The COT report is published weekly by the CFTC that contains an up-to-date information on futures market operations. The Fed’s hold which sent the dollar tumbling and bond yields falling. Gold has negative correlation with both Bond yields and the dollar and so gold moved up. Bullish bets on Gold have been reduced to more than five year lows. Hedge funds have re-entered bearish positions similar to that seen in late July. Hedge funds and other speculators shifted to a net-short position (bearish) in Gold for the first time in July 2015 in the history, as per the record maintained by the U.S. government since 2006.

Dovish Tone of Fed’s Monetary Policy

On September 16 & 17, the Federal Open Market Committee (FOMC) reviewed its monetary policy that was eagerly awaited by markets across the globe. The Federal Reserve decided to leave its benchmark fed funds rate near zero. The Fed has not raised interest rates since 2006 and has kept its benchmark rate at a record-low level near zero to support economic recovery since the financial crisis.

Fed outcome has confused and made markets uneasy by failing to raise interest rates but sticking to their expectation to hike by the end of the year. The Fed also emphasized stress in overseas markets, such as China. Concerns about the country’s slowing growth has rocked equities and other assets around the world in recent weeks. This has added a little more uncertainty in terms of what Fed is thinking.  Hedge managers are concerned that a further delay will keep markets on edge and the global market volatility that upended investors over the last six weeks may continue this year.

Since the 2008 crisis, the US Federal Reserve resorted to various measures to pump in liquidity in the US economy. The Federal Reserve launched three rounds of quantitative easing (QE) buying mortgage-backed securities worth $600 billion in each first two rounds and open-ended monthly purchases up to $85 billion per month till the end of 2014. Quantitative Easing increased money supply. Fed kept interest rates at near zero ensured that inflation does not fall below target. It stimulated consumption and growth. The result has been a massive rally across asset classes.

Overall labor market conditions have continued to improve and the unemployment rate has declined. While inflation continues to run below its 2 percent longer-run objective, it is partly due to decline in energy and import prices. So hedge fund managers and investors were expecting now tighten of monetary policy.

Fed Chair Yellen expects US rate increase later this year

Yellen stated in the press conference after FOMC meeting that the central bank was holding off until it sees “some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.”

“Recent global economic and financial developments are likely to put further downward pressure on inflation in the near term. These developments may also restrain U.S. activities somewhat,” Yellen said last week. “Heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.”

Within a week of FOMC meeting, Fed Chair Janet Yellen tried to clarify the Fed stand. In her latest speech at the University of Massachusetts- Amherst on September 24, she said ‘gradual pace of tightening’ is expected to follow first rate hike later this year. Her speech offered a relatively optimistic view of America’s prospects despite ongoing fears of a slowdown in China and turmoil in world financial markets. So far those concerns do not warrant a change in the fundamental outlook at home, she added.

But hedge fund managers continue to doubt the timing of interest rate increase and believe uncertainty about the Fed’s plans would linger volatility in financial markets till 2015 end.