The ‘bankies’ and the ‘hedgies’ go to war - but which is right?

In Anthony Trollope's coruscating novel, The Way We Live Now, Victorian high society is first seduced and then shattered by the spirit of stock market speculation, personified by the fraudulent financier Auguste Melmotte.

Those interested in financial crises should read, mark, and inwardly digest this marvellous work, for few authors have better captured the transition of market sentiment from euphoria to doubt to outright panic.

At the very zenith of his fortunes - the moment when he is elected to the House of Commons - Melmotte is hailed as a hero by "the new farthing newspaper, The Mob", which preaches "with reference to his commercial transactions the grand doctrine that magnitude in affairs is a valid defence for certain irregularities".

Yet already the first rumour has begun to circulate about Melmotte's inability to complete the purchase of a country estate.

In a flash, the rumour spreads from the vendor's lawyer to Westminster and from there to the City. "People might think. People might speak. People might feel sure. And then a crash would come."

Within a matter of hours the crash has indeed come and Melmotte, ruined, is found dead, having elected to elude his creditors by committing suicide.

There was just a whiff of a Melmotte moment last week in those parts of the West End of London where many hedge funds have their offices.

Reservations in swanky restaurants were being abruptly cancelled. Embarrassed letters were being sent out to investors. "Is it the end of the world?"

I heard someone ask. It was certainly the end of the summer of love (and low volatility) that was being celebrated at the "Hedgestock" festival just 12 days ago.

Hedgestock was billed as "a Festival of Networking for the Hedge Fund Industry". As at Woodstock, The Who topped the bill.

The difference was that at Woodstock, the audience was high, whereas at Hedgestock, it was their net worth that was high. How Trollope would have relished its hubris.

For, just a week later, many hedge funds were on the wrong side of financial nemesis. May was bad enough, to judge by some reports I've seen. June could end up being remembered as the month of Hedgestop.

By the close on Wednesday, there wasn't a single stock market in the world that hadn't fallen over the past month.

Emerging markets took the biggest hits, including Brazil, Russia and India. Along with China, they were supposed to be the BRICs - Big Rapidly Industrialising Countries. This month they dropped like bricks.

Developed markets have also been suffering, particularly the Japanese and German. Oil, gold and other commodities also fell from their recent highs. On Thursday, to be sure, the markets bounced back. But on Friday the rebound fizzled out.

What on earth is going on? Less than two months ago I was at a major hedge fund conference in California where sentiment towards all asset classes - equities, bonds and commodities - was almost overwhelmingly bullish.

Only a few participants agreed with me that a painful return to volatility was coming soon.

The explanation is that hedge fund managers and central bankers - call them hedgies and bankies for short - do not think alike. To be precise, the bankies have longer memories.

The grand panjandrum of the Federal Reserve, Chairman Ben Bernanke, has been learning the hard way that sometimes words can speak louder than actions.

Having said, on April 27, that he and his colleagues might "decide to take no action. in the interest of allowing more time to receive information relevant the outlook" (translation: "Don't assume we're going to raise interest rates again"), Bernanke realised that this was just another borrow-and-buy signal to the hedgies.

Suddenly Chairman Ben was struck by a horrible thought. Perhaps he'd been too soft. Perhaps the combination of surging commodity prices and credit growth might transport the world back to the inflationary 1970s.

On May 23, he changed his tune. There were, in fact, "upside inflation risks". Less than two weeks later, he was pledging anti-inflation "vigilance". Translation: "Sorry, what I meant was that we really are going to raise rates."

Bernanke is worried about inflation because that's what bankies worry about. Now, you might think "core" consumer price inflation of 2.4 per cent (the latest US rate) wasn't much to worry about.

Inflation rose six times higher than that in the 1970s. But any rate that's higher than the Fed's not-very-explicit-but-low target makes the bankies nervous.

The same is true in Britain. Last Monday, the Bank of England's Governor, Mervyn King, warned us to expect "a somewhat bumpier stretch of the road" ahead. Why?

Because while following and more or less hitting its 2 per cent inflation rate target, the Bank may have been underestimating the global forces - cheap Asian imports, cheap East European labour - that have been driving unemployment down and growth up.

In a booming, globalised world, the bankies now tell us, their monetary policy may have been "too accommodative" - hence the recent bubbles in equity, property and commodity markets.

The Bank of Japan started saying this kind of thing some time ago. So did the European Central Bank.

This apparently uncoordinated global tightening of monetary policy effectively shears the hedgies. For years, they have been making stupid money by borrowing from central banks at near-zero rates and taking long positions in any market with momentum.

"Too accommodative" central banks meant one-way bets and low volatility. Now it costs money to borrow and volatility is back.

The key point, however, is that many hedgies fear the bankies are over-tightening. They fear a sharp slowdown, if not a recession, in the United States and therefore in the rest of the world.

If they're right, the bankies will turn out to have been like generals fighting the last war.

This explains an important but under-reported feature of the past few weeks. It has been equity markets not bond markets that have gone haywire. If investors were really worried about inflation - which is invariably bad news for bonds - that would not have been the case.

Unlike Ben Bernanke, who got his PhD in 1979, the hedgies don't remember the Seventies. Most of them were still in short trousers back then. Yet they may turn out to be nearer the mark than the inflation-targeting bankies.

For one thing, there is little evidence so far that higher rates are actually reducing credit growth. The Fed's latest "Flow of Funds" report shows that in the first quarter of this year, household borrowing in the US was 32 per cent higher than a year before.

That's huge. It means that higher rates haven't yet translated into retrenchment by highly-geared American families.

Growing US household debt has been the single biggest driver of global growth in the past five years. When Americans do finally stop borrowing and start saving, the effects could be bigger than the bankies anticipate. (Fact: 29 per cent of borrowers who took out mortgages in the US last year have no equity in their homes or owe more than their house is worth.)

My guess is that belts are already being tightened. Certainly, consumer confidence has fallen to levels we've seen only twice in the past ten years.

"Magnitude in affairs is a valid defence for certain irregularities": I often think of Melmotte's motto when I walk through the West End, where the hedgies hang out.

The way we live now is, of course, different in many ways from the way Trollope's contemporaries lived. (They didn't have Big Brother or the World Cup.) But certain things remain the same.

"All the world knew that just at the present moment money was very 'tight' in the City," is Melmotte's reply when his creditors press him for payment.

Thanks to the bankies and their inflation targets, money is tight again today, and getting tighter. How long before the first big hedgie is pushed over the edge? Or will the bankies blink first?
 

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