The Funds That Failed To Capitalize On The Single Biggest Macro Trade

by: John M. Mason


Many macro hedge funds have suffered in recent years by assuming that there would be faster economic growth, higher rates of inflation, and higher long-term interest rates.

The investors in these hedge funds have been sorely disappointed as economic growth has remained tepid, rates of inflation have fallen, as have longer-term interest rates.

Maybe these funds are working with out-of-date economic models and should be more attuned to financial market changes over the past forty years or so.

Miles Johnson, in the Financial Times this morning “Are Macro Investors Suffering Because of 'Pseudo-Science'?” His subheading reads, “Funds Focused on Forecasting Big Economic Trends Have Struggled Amid Low Volatility.

“This year the advocates of macro-driven forecasting and trading are again in retreat. Some of the best-known macro-focused hedge funds have suffered a poor first half, compounding years of mediocre performance since the financial crisis. The reflation trade—a bet based on rising interest rates and economic growth driven by more expansionary politics in the US and Europe—has not performed as expected.”

The point is that ever since the end of the Great Recession…the recovery began in the third quarter of 2009…these macro funds have bet on the historical research that showed expansionary fiscal and monetary stimulus would produce faster economic growth than the compound 2.1 percent rate of growth attained in the United States and would also create increasing rates of inflation along with rising long-term bond yields as inflationary expectations got built into interest rates.

As I have written over the past seven years or so, many economic forecasters have constantly sought to identify the “green shoots” connected with rising economic activity and inflation.

Didn’t happen. And, it appears likely that this scenario is not going to emerge over the next several years, if at all this time around.

But, this disappointment has impacted not only some in the hedge fund community, but can also be seen in central banks in the US and in Europe.

Paul Hannon and David Harrison capture this attitude in the Wall Street Journal in their article titled “Weak Inflation Vexes Central Banks.”

“Leading central banks plan to withdraw some of the stimulus measures they have put in place since the financial crisis. But their timing seems a little puzzling: Inflation, which is already below their targets, is falling world-wide.”

“The decline in inflation is a mystery since the global economy appears to be growing at a faster pace than during recent years, while unemployment rates continue to edge lower.”

What is going on here? What happened to Milton Friedman’s statement that “inflation is everywhere and in every case a result of excessive monetary growth.” The Nobel-prize winning economist built a large part of his reputation around his historical research into the high correlations its between the growth of a country’s money stock and its resulting rate of inflation.

The subheading to this article asks the right question: “Weak growth in prices questions traditional model of linking output and prices.”

Seems like there are a lot of economic models that are coming under question these days.

Another economic relationship, captured in what is called “the Phillips Curve” presents a tradeoff between the rate of inflation and lower rates of employment.

“The Phillips Curve” has been one of the backbones of monetary policy at the Federal Reserve since the late 1960s…and into the current policy-making regime. “The Phillips Curve” has been the justification of the Fed’s efforts to stimulate higher rates of inflation so as to achieve lower and lower rates of unemployment.

Maybe the old models don’t work anymore. Maybe some of the old relationships have ceased to exist.

Milton Friedman was one of the first economists to question “the Phillips Curve.” His argument was that any current relationship between inflation and the unemployment rate was based upon the current state of market expectations. If a central bank were to achieve a slightly higher rate of inflation, which achieved a lower unemployment rate, the further result would be that inflationary expectations would change. The trade off would no longer be the same.

As a consequence, to keep the lower rate of unemployment, the central bank would have to generate an even faster rate of inflation. And, as inflation picked up at the end of the 1960s and into the 1970s, Mr. Friedman’s concern proved to be correct.

But, another thing change in expectations took place. As I have written about many times, the changes in inflationary expectations and the expectations about the governmental policies that produced these changing expectations took on another form.

As these expectations changed, investors responded by directing more and more funds into assets and the inflation that occurred took place in asset prices. Housing prices began to accelerate in the 1970s and then gold prices took off. Other asset prices became inflated as the government pursued policies that produce what I have called credit inflation.

And, this credit inflation got built into the economy in a big way as financial innovation took over in the later 1970s, 1980s, and 1990s. Some have labeled this movement as the “financialization” of the US economy. As this “financialization” took place, more and more monetary stimulus found its way into the “financial circuit” of the economy, and less and less of the stimulus went into the “industrial circuit” of the economy.

Ultimately the financial innovation created a disequilibrium situation that ended in the financial collapse that began in late 2007 and expanded into the following Great Recession.

The economy recovery that followed the Great Recession has been extraordinarily tepid and the Fed’s efforts at quantitative easing have produced neither the economic growth nor the inflation that many analysts thought would occur. The monetary stimulus has not gone into the industrial circuit and, consequently, has not produced the inflation that many expected.

But, wait, what about the quantitative easing? Mr. Johnson closes his article on the performance of macro hedge funds with the following comment: “The question the frustrated investors of these hedge funds should be asking is why they have failed to capitalize on arguably the biggest single macro trade of their generation: quantitative easing. If, as the macro mantra goes, the trend is your friend, why have the performances of this type of funds largely missed the rallies in equities and bonds that many believe has been largely driven by central bank intervention since 2008?”

Where these macro hedge fund mangers working with the wrong model…a model that became less and less relevant as the financialization of the economy progress. Whereas, many investors, as I have written about constantly, have argued that one shouldn’t fight the Fed, and continued to invest in stocks, these macro hedge fund managers worked with out-of-date models that insisted that monetary stimulus did not change expectations and that more and more quantitative easing must cause greater price inflation.

What model of monetary stimulus are you working with? And, what will happen when the central banks all begin to reduce the size of their balance sheets?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

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