Ice skating on a warm February pond

I was speaking to some old colleagues not long ago about hedge funds, in the context of how many fund managers had fallen for the siren song of “investing” in crypto and, given the open nature of their fund mandates (which can in many ways be boiled down to “make money in ways that aren’t boring so investors feel justified paying higher fees than in a mutual fund”), there were effectively no brakes on them piling in. One lamented the fact that he had never been given the opportunity to have such an open investment policy; he had been an equity fund manager and was limited to buying public common stock, listed on major exchanges, with limits as to single name concentration and industry concentrations and minimum holding periods. Another guy (alas, we were all men) talked about how fixed income was quite different: sure, you could take credit bets here and there, but ultimately, the general level and shape of the yield curve drove your returns, and since the Fed was essentially “the house” and could whipsaw the curve at will, he felt like his decisions were always just different shades of lipstick on the proverbial pig.

I took a somewhat different stance. I’ve never run a full-bore hedge fund, but back when I started my career, I had a somewhat hybrid experience of running a general purpose arbitrage fund. The mandate was to beat the return of money market funds, with the same risk profile (ie., effectively none). But there were no real constraints on what we could do in pursuit of that goal. A core strategy, for example, was futures arbitrage: we bought the underlying stocks or bonds of a given futures contract and shorted the futures against it – or at least, we did so when the market implied a carry rate on the contract in excess of regular money market returns. As long as we held on to the underlying and delivered into expiration of the futures, we had a “guaranteed” return – although I was taught, both formally and by experience, that the guarantee required holding the position to maturity, required confidence that the underlying you had bought was, in fact, properly deliverable, that your futures broker didn’t go under during the life of the contract, and that you and your management had full faith and confidence in the Chicago clearinghouses to make good on the contracts at expiry.

What I explained to my friends, though, was that it was the constraints – the career maintenance requirement that at no time would I lose money relative to just buying and rolling overnight time deposits – that made the job incredibly fun. I was supposed to find what in markets should be imaginary creatures – riskless performance superior to the performance of a riskless asset – and do so with billions of dollars, over and over again. And for seven years, I did it. Indeed, what eventually ended that halcyon period was being given the reins of a higher risk fund, which by definition would take bigger risks and would thus theoretically potentially have losses in excess of that theoretical money market fund comparator. I took bigger risks; I lost a bit of returns; and it turned out that management didn’t really buy into the idea that losses were okay and I found it expedient to look for employment elsewhere.

Subsequently to that, I managed bank balance sheets, and having brought the experience of that first career stint with me, I took pains to understand exactly what the constraints were – in other words, what losses were acceptable and what losses were not. I quickly realised that banks, in managing their balance sheets, don’t worry so much about whether a single investment loses money, especially due to changes in rates. They worry about the net gain or loss between what the bank is earning on its assets and what it pays on its liabilities. My job was to balance those two with the broader objective of increasing the net return over time. The constraints, moreover, were orders of magnitude more complex that what investment managers face in the “regular” funds world. I was using maybe 20% of the balance sheet to augment and diversify the other 80% of the assets – mortgages, credit card loans, lines of credit – and was trying to raise about 50% of the balance sheet in institutional funding markets while keeping a strong eye on what the deposit people were doing to bring in customer funds. When times were good, it felt like ice skating blindfolded on good smooth ice, but you always knew the ice might start getting chewed up – and you were never sure how thick the ice was and whether it would hold your weight if you fell down. I loved it, but to be sure, the ice broke more than once.

I’ve thought about this quite a lot recently, though not so much for what I do – I consult with banks on how to manage their balance sheet, but I’m no longer doing the skating, and I manage a small hedge fund, but it’s simpler conceptually than any investing I’ve ever done, even if what I’m buying and selling is intricate and complex to value and trade. Where it’s come into my thinking has been in thinking of the Fed and how it’s managing the money markets these days.

It should be noted that every bank treasurer I’ve ever met who’s worth his or her salt ultimately wants to be either a Fed governor, ideally the Chair, or running the open market operations desk for the New York Fed, essentially the head of portfolio management for the largest and most significant bank balance sheet on earth. I’m no different; that latter job, in New York, from an investor perspective is actually a bit boring – the market knows how you need to trade before you do – but it’s the interaction with the market, and the influence of being the go-to person for the rest of the Fed on the constant question of “so what’s the market really thinking about us?”. My fellow traveler here on the site, Mark, once served in that role for the Bank of England on their short term money desk – admittedly a bit of a junior currency regime relative to the US dollar system, but still, a part of me will always be green with envy that he had that desk for a period of time. I think often about what I would be doing today, at 9am on a Wednesday in February 2023, if I were sat at the screens in lower Manhattan instead of in front of my laptop on holiday in the Hamptons.

The Fed doesn’t just operate the largest single balance sheet on earth; it also sets the price of overnight money for the rest of the US dollar banking system. It is, after all, both the marginal buyer and seller of dollars to all other parts of the market – either directly, through its discounting and repo operations with banks and primary dealers in the US Treasury markets, or indirectly, as the rest of the market ultimately transacts with those banks and dealers and their capacity is set by what the Fed demands of them or they demand of the Fed. But in operating the rest of the balance sheet – funded by deposits from member banks, by currency outstanding, and by excess government balances – it creates ongoing indirect impacts on the demand for money and, thus, for the stability of the rate which it sets on money. If the balance sheet gets too big, the Fed can inadvertently distort the long term price of money, which then creates pressures on the short term demand for money depending on how they set the overnight rate. If the balance sheet gets too small, banks may be forced to place excess deposits in riskier assets, which can result in inflationary pressures which ultimately may require an increase in the short term rate, which in turn can stifle economic growth.

And the Fed has two missions. The first – to maintain long term stability in the value of US dollars – gets the most press, or at least it does for me because I’ve lived in the financial markets for going on thirty years now. The second, though – to enable monetary conditions consistent with the maintenance of full employment in the US economy – is the real kicker. Those objectives aren’t always in alignment, even if over the long run, there’s good reason to believe that economic systems engender optimal employment conditions when price stability is maintained. In the short run, however, Fed governors get appointed, confirmed, reappointed, and retire; in the short run, there are elections of the presidents who choose the governors and of the senators who confirm them; in the short run, the financial and popular press (and in today’s world, social media) interpret for the voters whether there is or is not alignment and regularly tell the Fed just what they think of the balancing act. If, back in the day of running a short-term arbitrage fund, I was ice skating blindfolded, then the Fed (and its system manager) ice skates blindfolded, with a rhino strapped to their back, as the warm springtime sunshine is starting to melt the ice.

Twelve months ago, as inflation started to spiral upwards, plenty of commentators (and politicians) blamed the Fed for “waiting too long” to rein in inflationary pressures in the monetary system as the economy returned to normal after COVID lockdowns and as the cumulative impact of $5 trillion in fiscal stimulus started hitting the economy with full force. Such criticism was ridiculous: most of the nattering nabobs of the publishing classes found it convenient to forget that there had been quite recently a pandemic which resulted in the largest two-quarter decline in GDP in history; anything the Fed would have done would have been at least somewhat wrong, and to have gotten it “wrong” in a way which maintained broad employment stability should have been cause for celebration, not whinging. But even beyond that, the short term blinders which focused on “inflation surging higher” ignored the prior decade of below target inflation, which had led the Fed to attempt monetary stimulus that led to the disruptive asset bubbles in real estate and other long-term assets which were beginning to harm household balance sheets. If anything, it was to the good that the Fed let inflation run up a bit – especially since the resulting sectoral decline in real and financial asset prices which we’re still observing is doing much to normalise wealth imbalances in the US domestic economy.

Now, with unemployment at historical lows – so low, in fact, that wage pressures continue to build – and with inflation still running well above historical averages, let alone its own target, the Fed is being criticised for potentially “overshooting” on rate hikes. Or worse yet: some observers believe the Fed will be “forced” to engender a recession in the US in order to get to the long-term target inflation level of 2%, with a number of articles in the past couple of weeks suggesting that the Fed should do away with the 2% target and allow inflation to run higher, longer, so as to ensure no job losses.

This all serves to remind me of that first job I had, running derivatives arbitrage strategies. There was one objective, well understood: beat the returns on overnight deposits. There was one iron clad constraint: don’t lose money, ever. That meant the returns were rarely stellar, but management also didn’t have to ever go back to investors and explain a loss. Then I was given what in theory was a “more fun” job: beat returns on overnight deposits by a lot – clear enough – but the constraint got squirrelly. It wasn’t “don’t lose money, ever”; rather it was “try not to lose money, but you’ll only know that a loss was too big after the fact”. That second job sucked.

At the banks I managed as treasurer, the objectives were actually quite tricky: some mix of meeting risk targets, “optimising” net interest margin, maintaining adequate ready liquidity, but the constraint was back to iron clad: always make sure your capital levels exceeded minimums with a cushion, and always have enough cash to pay the bank’s obligations on demand. I love that world of hard constraints – even if they are multi-dimensional, even if they sometimes were contradictory. The lack of ironclad objectives meant that there was always room for someone – a head of commercial lending, say, who thought they were being charged too much to fund their loans – to complain about how well I was doing my job, but with hard constraints to fall back on, I could find a way to navigate the bank with firm knowledge of, as it were, where the ice was getting thin.

The Fed has its constraints, loosely worded as they are, and the very size of the Fed and of the US dollar economy at which it stands at the centre mean by definition the job of managing their balance sheet is impossible to get right. Indeed, as the press reminds us (in particular with its own lack of memory), if you get it right in one period, it’s assumed you’ve planted the seeds of failure in the following one. Managing with such background noise as that must be intensely stressful, but the Fed’s governors have done an admirable job, and show no signs of cracking or falling prey to obvious mistakes. And arguably, they’ve done better than most other central banks – Japan, Canada, UK, the EU – despite the external noise, and despite being the obvious magnet for global monetary criticism. I think, though, it’s the fact of their constraints that enables such success.

Hedge fund managers often seem like the ubermenschen of the capital markets. The press avidly tracks their yacht and real estate purchases, and hangs on their pronouncements, whether it be on corporate governance or management style or talent selection. But in reality, most hedge funds die and fold quietly, and for every Citadel, there’s a dozen crypto and meme fund blowups. On the other side of the coin, the constraints we place on banks, on money market funds, and on our central bank are the unspoken key to their long term sustainability and success.

As we think about what may be required to face larger global challenges – global warming, for example, regardless of what you think its origins may be, or pollution control, or demographic changes – it’s worth reminding ourselves that the constraints are what bring out the most creativity and, ultimately, the most consistent success. We might miss out on the next upside trade, but knowing how to skate the thin ice is what will keep us alive.