After slamming shoppers, manufacturers and tech giants alike, inflation is poised to claim a new set of victims: Wall Street’s smartest hedge funds.
Caught flat-footed by the Federal Reserve’s plans to begin tapering its bond purchases — confirmed by the central bank on Wednesday after more than a week of market-churning speculation — a slew of top-tier hedge funds are now coping with losses from overly optimistic bets that inflation is only a temporary phenomenon.
Last week, major money shops including Cedar Rock, Edgewood, Viking, Marshfield, Point72 and Lone Pine appeared to sell out of some stock positions at such a clip that they raised eyebrows, sources told The Post.
According to some insiders, the funds were surprised when bond yields moved against them as it became increasingly apparent the Fed planned to begin to turn off the spigot of bond-buying that has helped prop up the economy through the pandemic.
“Nobody on Wall Street has ever seen inflation in their career — there hasn’t been elevated and persistent inflation in the last 20 years,” said Michael Taylor, managing director at Critical Mass Partners. “The market has changed since the last time we had inflation. Most managers don’t know what to do because they have no experience in this realm but they’re ill equipped to prosper.”
Inflation has been stubbornly stuck at a 30-year high, according to the government’s latest reads — running at a rate of 3.6 percent when compared to the same time last year and far outstripping the Fed’s own guide for prices to rise around 2 percent. The Fed’s read strips out food and energy costs, which it claims can be volatile: Including those costs, prices are rising even faster — up 5.3 percent in recent gauges.
Worries over inflation have sparked a surprise flattening of the so-called yield curve — often seen as a proxy for economic conditions. The flattening is also a signal that investors are worried about slowing growth and rising interest rates. In this case, some investors are worried that the Fed will have to eventually yank rates quickly to slow inflation, a worry that’s showing up in higher rates for shorter-term debt — and the move that caught some hedge funds by surprise.
“Hedge funds have a history of a short interest-rate strategy on bonds and it doesn’t go well,” said Chris Whalen, chairman of Whalen Global Advisors. “Funds are highly levered with bonds — and when you’re wrong you’re really wrong.” In other words, if you’re counting on low interest rates for short-dated bonds and then yields all of a sudden spike higher, you can be caught holding the bag.
And as funds react to persistent inflation, the next shoe to drop will likely be when the Fed hikes rates. “I think the Fed will be behind the curve and both the pace and scale of tightening will be a negative surprise as the financial markets are not prepared for it,” Charles Myers, chairman of Signum Global Advisers said.
For hedge funds, whose bread and better is leverage, inflation and rising rates could squelch profits.
“There are consequences to having inflation – there will be dramatic consequences for shops with lots of leverage,” Taylor adds. “Highly levered funds cannot generate positive returns with a high cost of capital.” Hedge funds will have to improve profits to make up for the higher cost of money at the same time markets will be getting choppier amid tapering, higher rates, and a steepening yield curve, sources add.
“Next year is anyone’s guess,” Taylor adds. “Between a possible coronavirus resurgence, inflation, tapering…. it could be extremely difficult.”
Those who’ve been around the block are raising the alarm bells about persistent inflation. “Have to bet on more market volatility given uncertainty about the virus, inflation persistence and the strength of the recovery,” Ian Bremmer, president of Eurasia Group, told The Post. “More broadly, inflation is going to be a more important factor for wall street, for our politics, and for policymaking in 2022.”