Unintended Consequences Of Bernanke's Fed Hedge Fund

by: Jason Schwarz

To taper or not to taper is the obvious short-term catalyst moving the market. Beneath the surface, however, a deeper issue is at play. Under Ben Bernanke's leadership the Federal Reserve has evolved into the world's largest, most activist hedge fund. No longer do we rely on the Fed to simply set interest rates, QE 1, 2, 3 and 4 changed that. This recent $85 billion monthly purchase plan of treasuries and mortgage backed securities has evolved the Fed from participating in markets as a rule setter/referee into a primary participant. What's wrong with the Fed becoming the world's largest hedge fund? Where to begin.

Because of the anticipatory nature of the market, hedge funds actually operate most efficiently in the shadows. For example, if a large hedge fund telegraphed to the market that over the next three months it plans to liquidate its entire stake of Google (NASDAQ:GOOG), what would happen to GOOG shares? It would be a race to sell by other market participants who hope to avoid the selling pressure as that large hedge fund ends up getting crushed on its measured trade. This is why hedge funds only tell you what they did after the fact. Otherwise overreactions would occur in anticipation of the selling or buying pressure. We're concerned that this anticipatory overreaction phenomenon is on the verge of happening in conjunction with the Fed's QE exit strategy. Bonds will drop. Stocks will drop. Gold should drop (GLD had dropped from $137 to $132 over the last 2 weeks). The only thing that will rise in the short run is interest rates.

In addition to instituting QE, Bernanke has also raised the level of transparency at the Fed which may end up causing negative unintended consequences. It is a difficult thing to tell the market what you plan to do in advance of doing it, especially when we're talking about the draw down of a successful program. From our perspective, it would increase stability in the market if the Fed lowered its $85 billion program down to $65 billion and then $45 billion while telling the market what it did after the fact. Under this scenario the uncertainty of change is eliminated because it already happened.

Tuesday's up market is suggesting that Bernanke will be able to avoid a worst case scenario with the taper. However, economists aren't yet on board. CNBC said it best when they stated 'any whiff of what the Fed might do sends markets reeling'. Fed watchers are becoming more convinced that the taper will begin in 2013 so that the policy shift is priced in before Bernanke's successor takes over in early 2014. President Obama stoked taper fears Monday night when he suggested Bernanke's time is up. On May 22nd, Bernanke himself said that the Fed could begin to reduce its purchases in the next couple of months if it sees sustained improvement in the economy. We expect he will utter similar sentiments today and a lack of confidence in the Fed's commitment to this program will ensue.

Navigating a market in which the Fed acts as a central player rather than a referee makes for volatile action. What we're seeing now is just a glimpse of things to come in the fall. Each time the Fed speaks it represents a tipping point for the market; as the year progresses the negative bias to the tipping point should grow stronger. Our portfolio strategy is to hold a small allocation of index puts ahead of these Fed events and then adjust accordingly in the aftermath. As I mentioned in yesterday's post, if Bernanke alleviates all short-term tapering fears (we don't think he will), we'll load up the portfolio with index calls, Apple (NASDAQ:AAPL), Tesla (NASDAQ:TSLA) and Yahoo (YHOO) sooner than expected. But if Bernanke does what he did on May 22nd, we'll remain cautious and look to profit from downside pressure over the next six weeks.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY, AAPL, YHOO, GLD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.