Hedge Fund Skeptics Warn on ‘QE Infinity’

“A man’s got to know his limitations,” says “Dirty Harry” Callahan, the gun-toting, rule book-ignoring cop immortalized by Clint Eastwood in “Magnum Force.”

United States Federal Reserve
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United States Federal Reserve

It is a principle the U.S. Federal Reserve – which earlier this month embarked upon its own, third bout of “unorthodox” enforcement, “QE3” – could learn from, according to Stephen Jen, the former Morgan Stanley foreign-exchange guru turned hedge fund manager.

“The Fed officials are some of the smartest economists around,” he wrote in his most recent note to clients. The trouble is, said Mr. Jen, “they know everything except their own limitations.”

Barely two weeks on from Ben Bernanke’s announcement of potentially unlimited bond-buying by the Fed, and concerns like those of Mr. Jen are reverberating across the hedge fund industry.

Among the trading rooms and floors of Connecticut and Mayfair, supposedly sophisticated money managers are raising big questions about QE3 — and whether, this time around, the Fed is not risking more than it can deliver.

Such scepticism is not easy to maintain. “When I started out in asset management I was told two rules: the trend is your friend and don’t fight the Fed,” says Luke Ellis, who oversees $19.5 billion in hedge fund investments at Man Group’s FRM. “For the first time, we now have the Fed fighting the trend.”

All of which is not to say hedge funds do not agree on where markets will go in the coming weeks.

Fund managers can easily reel off the broad outcomes of a third bout of quantitative easing: a weakening in the dollar, a rally in commodities, and almost certainly, a rally in equities.

“QE3, or QE Infinity, as some have branded it because of its open-ended nature, will certainly push global asset allocators to look increasingly at riskier asset classes,” says Guillaume Rambourg, founder and chief investment officer of Verrazzano Capital. “Equities should ultimately benefit.”

Indeed, as Credit Suisse’s Andrew Garthwaite noted in a global equity strategy note following the Fed’s announcement, equities have rallied 10 to 15 percent in the six weeks following the last two bouts.

Fund managers are even confident enough to point to specific sectors they expect to benefit: cyclicals and stocks with high dividend yields are attractive plays.

In commodities, hedge funds’ bullish positions were at a 16-month high in mid-September, according to data from the Commodity Futures Trading Commission.

And gold is again in vogue after a painful sell-off at the beginning of the year. Last week, at a conference hosted by the Council on Foreign Relations, Ray Dalio, founder of the world’s biggest macro hedge fund, Bridgewater Associates, said he knew of “no sensible reason” not to hold the precious metal.

But the hedge fund bull case is grudging. Speaking to the Financial Times last week, one of the leading U.S. hedge fund managers said the Fed’s actions were, in no uncertain terms, a disaster waiting to happen.

If others are not quite so outright negative, they are certainly curbing their optimism.

“Having been constructive on markets for over three years, based in large part on the view that liquidity would continue to drive markets, I am inclined to be more cautious,” Michael Hintze, the founder of CQS, Europe’s biggest credit hedge fund manager wrote to his clients this week. CQS manages assets of $11.6 billion, and the fund Mr. Hintze himself runs at the firm is up 23.5 percent this year on the strength of his views.

“It looks to me as though each round of central bank stimulus is having a diminishing effect,” his letter continues.

“Central bank (and government) actions may have stabilised markets and economies, but they have also ‘kicked the can down the road’. They have not resolved the fundamental underlying issues that need to be tackled for a broad-based and sustainable macroeconomic recovery.”

One key indicator in particular seems to make hedge funds’ caution clear: measures of the industry’s net exposure – the degree to which a fund’s portfolio is long, or short biased – show a much diminished appetite for long-risk this time around in comparison with previous QE-driven rallies.

“The relationship [between risk asset prices and economic fundamentals] has become a little stretched,” says Tomas Jelf, chief economist at macro fund Prologue Capital. “Risk assets will really need to see some economic traction if they are going to stay buoyant beyond the next round of quantitative easing.”

The jury is still out as to whether QE will create such growth. Certainly a weaker dollar will spell further trouble for the euro zone economies, whose difficulties have already cast a significant pall over global growth expectations.

The bigger problem is that the Fed’s ability to affect markets is as much a matter of credibility as it is monetary heft, say hedge funds, and it is that credibility — a much more difficult concept to grapple with or put a number to — that may be eroded.

“They are in danger of losing some of it – not in terms of their inflation fighting credentials, but in terms of their ability to be seen as effectively impacting the economic cycle,” says Mr. Jelf.

The Fed needs savvy, market-moving investors such as hedge funds to listen and heed what it says. Otherwise, the danger is that, like Mr. Eastwood in recent weeks, the Fed may soon find itself preaching to an empty chair.