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How Paulson and Other Hedgies Have Been Hoodwinked to 'The Gold Trade' - An Alternate View

November 14, 2013 | About:

Most hedgies will declare “inflation” is on the rise and it is worth it to own gold as portfolio diversification has almost thrown in the towel by now and moved on. Recall how Paulson lost $736 million in Q2, which raises questions: How did he manage to make the greatest trade ever yet not continue his winning streak again thereafter? (As of the recent quarter though he had outperformed his peers.)

No other hedgies run the world’s greatest hedge fund than Ben Bernanke. There are a few schools of thought that i) inflation will rise thus compelling almost every money manager to chase for yields ii) inflation will not see an uptick too soon since there is a slack in productivity and excess capacity in production

Witness the inflation chart here (Inflation print at 1.2% as of September 2013):


That $85 billion monthly purchase of assets isn’t really going into the system, working into an inflationary spiral. For simplicity sake, call it 80:20 of which 80% of that $85 billion is sitting on the bank’s excess reserves and the balance is currency in circulation or held by banks as required reserves.

How did Bernanke do it? Simple: Paying high enough interest on funds which banks deposit at the Fed. This has three consequences: 1) Banks don’t lend but continue to build up excess reserves to be a stronger bank 2) No inflation 3) Building up of confidence by producers and consumers which feed off itself, thus corporate earnings will gradually be on the mend and consumers will be confident to go out and spend.

Why does the Fed need such great excess reserves? With the ability to pay interest on excess reserves, the Fed can raise short-term interest rates that they offer to banks on deposits at the Fed and will place upward pressure on all short-term interest rates (i.e. to flatten the yield curve).

Key Takeaways:

1) It is a confidence game because when you think about it, the market is economics plus sentiment.

2) With a P/E ratio (15x to 16x) still below long-term average of 20x (for the S&P), there may still be room for the market to edge higher before the music stops.

3) The best hedgies anticipate not reacting like most average investors do.

Source Quote:

“We also discussed the importance of paying interest on reserves when the level of excess reserves is unusually high, as the Federal Reserve began to do in October 2008. Paying interest on reserves allows a central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities. The central bank can then let the size of these facilities be determined by conditions in the financial sector, while setting its target for the short-term interest rate based on macroeconomic conditions. This ability to separate monetary policy from the quantity of bank reserves is particularly important during the recovery from a financial crisis. If inflationary pressures begin to appear while the liquidity facilities are still in use, the central bank can use its interest-on-reserves policy to raise interest rates without necessarily removing all of the reserves created by the facilities.”

About the author:

Agnostic trader. CAIA and CHP charterholder. Twitter: @hedgefundtrades

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