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Hedge Funds' Long Shadow


Have hedge funds become a potentially destabilizing transmission mechanism of monetary policy? That's the intriguing question posed by David Hale, chief economist of Zurich Financial Services.

It's hardly surprising that Federal Reserve policymakers now keep a weather eye on the stock market. Rising stock ownership among the public and top executives has vastly increased the market's effect on consumer and corporate behavior. The capital markets have also made big inroads into bank lending's share of financing activity.

At the same time, says Hale, the huge swings in many high-cap stocks imply that the market has become more reactive to changes in monetary policy, as does the explosion in stock trading. So far this year, he notes, the level of turnover (shares traded relative to shares outstanding) is running at a 188% annual rate (373% in the case of technology stocks), vs. 128% in 1996.

A major factor in these developments, Hale believes, is the dramatic growth of hedge funds--private funds catering to wealthy folks and institutional investors that can sell stocks short as well as go long. Industry estimates indicate that such funds now manage $400 billion to $500 billion spread across 3,000 to 4,000 firms, and that new hedge funds are being launched almost daily.

Hale argues that hedge funds are changing the market's response to monetary policy. In 1999 and early 2000, when the Fed stayed relatively loose in deference to Y2K fears, the funds were primarily long the market and helped push prices sharply higher. After the Fed tightened, they began to short the technology sector, driving it sharply lower. And when aggressive Fed easing finally caused stocks to stabilize earlier this year, he says, their actions to cover short positions caused many stocks to rally sharply in April and May despite continuing erosion in profits and orders.

Attracted by the opportunity for arbitrage with the stock market, hedge funds have also been big buyers of convertible bonds. According to some traders' estimates, their holdings now account for roughly half of today's $188 billion convertible-bond market.

What's worrisome about the growing impact of hedge funds, says Hale, is that "they are so momentum-driven that they tend to encourage market overshooting both ways in response to monetary policy shifts." Their collective actions, he claims, helped drive the market to ridiculous levels of valuation a few years ago and sparked both the subsequent implosion of many large-cap tech stocks and their more recent rally.

The bottom line: A new and highly reactive channel is amplifying the impact of monetary policy on the stock market. Rising trading velocity associated with hedge-fund activity, says Hale, suggests that "we are witnessing an unprecedented institutionalization of speculation without any anchor in traditional valuation measures."

At the least, this implies that the financial system is becoming a lot more volatile--and that the Fed's task is becoming even more complicated. Back in the early 1980s, most Midwestern central cities appeared to be in a state of steady decline, buffeted by a continuing outmigration of people and businesses to suburban sites and other regions. During the 1990s boom, however, reports William A. Testa of the Federal Reserve Bank of Chicago, unemployment fell sharply, average real household income rose 15% to 20%, and many cities saw an influx of skilled service workers and empty-nesters seeking the advantages of city life.

Does this mean that the central cities are closing the growth gap with their suburbs? Not yet, says Testa. According to his analysis of 11 big Midwestern cities, their overall population nearly stabilized in the 1990s but their suburban populations still grew by 9%. Only Chicago, Minneapolis, Indianapolis, and Columbus, Ohio gained residents.

Further, although urban joblessness fell sharply, most central cities still suffered job losses in the 1990s, with just Chicago, Indianapolis, and Columbus bucking the trend. And despite healthy increases, average city incomes remained far below those in the burbs.

Testa's analysis indicates that the Midwest's urban revival was still a work in progress at the end of the 1990s. The big question now is how well the region's central cities will weather its current industrial recession, which is affecting many residents who travel to suburban jobs. There's good news for those concerned about the problems facing children living with single mothers in low-income families. According to the Center on Budget & Policy Priorities, during the late 1990s the share of U.S. kids living with single moms fell appreciably in households whose incomes were less than twice the poverty level.

The declines between 1995 and 2000 were particularly large among children in minority households, dropping from 47.1% and 24.6% of black and Hispanic kids, respectively, to 43.1% and 21.3%. In both cases, the proportion of children living with two married parents also rose. By contrast, the shares of black and Hispanic youngsters in single-mom families did not change significantly between 1985 and 1995.

The center doesn't speculate on the cause of the latest shift. But experts indicate that possible contributing factors include declining teenage pregnancy rates, increased wages earned by low-income workers, and welfare-system reforms. Whatever the reason, the change is welcome.


Steve Ballmer, Power Forward
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