"Astonishing" Pricing Anomalies

I believe the article “Hedge Funds Reap Rewards from Treasuries” in the Financial Times is a good read for people interested in the financial markets. (See http://www.ft.com/cms/s/0/a5aa3c38-c111-11df-afe0-00144feab49a.html.)

The authors, Sam Jones and Izabella Kaminska, start right out talking about “Classic relative value arbitrage” the investment strategy which “involves betting that price discrepancies between securities that normally trade at similar values should correct over time.” The implosion of Long-Term Capital Management brought this strategy to public notice.

Hedge funds have been making a “pretty penny” recently by taking positions based upon this strategy. The reason why a strategy like this has been working is that there are “astonishing” pricing anomalies being observed in the financial markets ever since the collapse of Lehman Brothers in September 2008.

Why have these anomalies occurred?

Thank you Mr. Bernanke and the Federal Reserve System!

“Instruments that should normally track each other almost perfectly saw their prices diverge sharply as investors panicked and central banks, including the US Federal Reserve distorted bond demand by buying up huge amounts of debt as part of the emergency efforts to pump more money into the economy.”

“Thanks to continued distortions in bond supply and demand, as well as jittery investors and political intervention, funds…have been able to exploit a rich seam of arbitrage opportunities.”

These opportunities have been “less risky” than might have been expected because the promise Mr. Bernanke and the Federal Reserve have made that their interest rate policy will continue for “an extended period.” So far, that period has lasted for twenty-one months and most expect it to remain in place into next spring…at least.

I have been arguing for months now that the interest rate policy of the Federal Reserve has been accounting for the profit recovery of the biggest banks in the United States. This interest rate policy has been subsidizing the big banks and has been producing a counterpoint within the government to the attack on those banks that are considered “too big to fail.” The Fed’s policy has been underwriting the process in which the big banks will get bigger and control more and more of the assets in the banking system as a whole.

The material being reported by Jones and Kaminska is the first piece of information outside of the commercial banking industry of how the Federal Reserve (and other central banks) have been underwriting the success of participants in other areas of the capital market.

“If 2009 was an excellent year, then 2010 is still a very good year. The opportunities are huge in some cases,” says Bob Treue, founder of the hedge fund Barnegat.

My best guess is that we will be seeing more evidence pointing to exceptional returns being made on the financial market distortions created by the Federal Reserve. One can also surmise that many, many other representatives of the wealthy are making huge gains on these market situations and we will never know about them because they will not have to be reported.

I am not against people making money. Actually, I am very much in favor of this result.

What I am concerned about is that the money that is being made on these arbitrage transactions is a part of explicit government policy and that the consequences of this explicit government policy contradicts almost all of what the Obama administration is saying it is trying to achieve!

The only justification that I can give for why the government is engaged in this contradictory behavior is that it knows something we don’t and that something it knows would be tremendously scary to us if we knew it.