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Generational Dynamics Web Log for 8-Jun-05
Alan Greenspan predicts major losses by hedge funds

Web Log - June, 2005

Alan Greenspan predicts major losses by hedge funds

But still says he doesn't have a clue why 10-year Treasury bond interest rates are falling.

In a speech on Monday to an International Monetary Conference in Beijing, that hedge funds had picked "most of the low-hanging fruit of readily available profits," and that very soon, "many wealthy fund managers and investors could become less wealthy."

Hedge funds are based on small inefficiencies in the marketplace. If, for some reason, copper is selling for slightly more in Moscow than Chicago, then hedge fund managers use a technique called "arbitrage": they purchase Moscow copper and hedge (or collateralize) the purchase by selling Chicago copper, and make money when the prices converge again.

According to Greenspan,

I have no doubt that many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield above-average rates of return. For the time being, most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital, leaving as a byproduct much-more-efficient markets and normal returns.

But continuing efforts to seek above-average returns could create risks for which compensation is inadequate. Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming.

Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy.

Note that Greenspan likes hedge funds. He says above that they leave "as a byproduct much-more-efficient markets," and later he tells us not "to lose sight of the very important contributions hedge funds and new financial products have made to financial stability by increasing market liquidity and spreading financial risk, and thereby enhancing economic flexibility and resilience."

The question is whether a collapse in hedge funds will bring down the whole market. Greenspan says it won't, but other analysts fear a market meltdown, as I wrote last month.

Why is the yield curve flattening?

Early in 2004, Greenspan was bragging that he'd saved the economy from repeating the 1930s Great Depression. However, many things started going wrong during 2004, and Greenspan's language became increasingly uncertain, and by February, 2005, Greenspan completely repudiated his earlier reasoning about the 1990s stock market bubble and its aftereffects.

Greenspan pointed to a special "conundrum": The flattening of the yield curve in bonds, which I wrote about last year.

The issue is that interest rates for long-term investments keep falling, while the interest rates for short term investments have been rising. Here's an update of the chart that I posted last year, showing the interest rates for short and long-term bonds for some recent dates:

Treasury Bond Yields

Date 3-month
maturity 10-year
maturity Difference

May 11 '04 0.94% 4.74% 3.80%

June 11 '04 1.17% 4.79% 3.62%

Aug 21 '04 1.38% 4.23% 2.85%

Sept 21 '04 1.60% 4.03% 2.43%

Feb 17 '05 2.44% 4.17% 1.17%

Jun 7 '05 2.86% 3.90% 1.04%


Treasury Bond Yields

Date	3-month maturity	10-year maturity	Difference

May 11 '04	0.94%	4.74%	3.80%
June 11 '04	1.17%	4.79%	3.62%
Aug 21 '04	1.38%	4.23%	2.85%
Sept 21 '04	1.60%	4.03%	2.43%
Feb 17 '05	2.44%	4.17%	1.17%
Jun 7 '05	2.86%	3.90%	1.04%

As you can see, the short-term rates continue to increase significantly, and the long-term rates have been decreasing or remaining steady.

Many analysts believe that the bond rates are trending towards an "inverted yield curve," where long term bonds have a lower interest rates than short-term bonds.

Whenever this has happened in the past, it was followed by a recession or a major stock market correction. (There's a great web page that discusses all this, and has a "living graphic" that shows how the yield curve has changed, month by month, since 1978, at The Living Yield Curve.)

Greenspan says that won't happen this time. OK.

In his speech, Greenspan says, "[By summer, 2004,] pressures emerged in the marketplace that drove long-term rates back down. In March of this year, market participants once again bid up long-term rates, but as occurred last year, forces came into play to make those increases short lived."

He added that this is happening around the world: "But what are those forces? Clearly, they are not operating solely in the United States. Long-term rates have moved lower virtually everywhere. Except in Japan, rates among the other foreign Group of Seven countries have declined notably more than have rates in the United States. Even in emerging economies, whose history has been too often marked by inflationary imbalances and unstable exchange rates, access to longer-term finance has improved."

Greenspan considers "a number of hypotheses" to explain "this remarkable worldwide environment of low long-term interest rates," but he rejects them, and finally concludes, "The economic and financial world is changing in ways that we still do not fully comprehend."

Generational Dynamics view

Generational Dynamics, in its current stage of development, does not predict the yields on Treasury bonds. However, Generational Dynamics does make financial predictions that provide an indirect explanation for why long-term interest rates are falling worldwide.

First, you have to understand how long-term bonds are priced. Suppose you purchase a bond that will pay $1,000 in ten years. The more you pay for it, the less interest you'll be earning over ten years. So, as the price of bonds goes up, the interest rate (or yield) goes down.

That's what's been happening with 10-year Treasury Bonds: the prices have been going up, meaning that the yields have been coming down.

If the prices are going up, it means that there must be a greater demand for these bonds. So the real question is: Why are investors around the world purchasing more and more long-term bonds, pushing their prices up and their yields down?

We know that many Asian companies have been buying up US Treasury bonds, as have hedge fund managers in the Carribean.

But this is a worldwide phenomenon, as Greenspan pointed out. It's not just US Treasury bonds, but also long-term bonds in many other nations. What possible explanation is there for this worldwide demand for long-term bonds for countries around the world?

Alan Greenspan has no explanation, and neither does anyone else.

But Generational Dynamics does have an explanation: It predicts that the world is going through a generational financial crisis. These have occurred every 70-80 years since the 1600s: Tulipomania bubble (1637), South Sea Bubble (1721), French Monarchy bankruptcy (1789), Hamburg Crisis of 1857, and 1929 Wall Street crash. These bubbles and crashes always occur at exactly the time when the generation of people who grew up and lived through the previous bubble all disappear (retire or die), all at once.

The 1990s bubble occurred at exactly the time that senior financial managers who grew up during the 1930s Great Depression all disappeared (retired or died) all at once. The effects of the 1990s bubble have not fully unraveled, and we're still in a bubble. Price/earnings ratios have been at 20 or above for ten years now, as I've written about many times, meaning that stocks are overpriced.

So what's an investor to do? Stocks are risky because they're overpriced. Hedge funds are risky because even Greenspan says they're going to lose money. Investing directly in companies is risky because most companies have become heavy with bureaucracy and pension fund obligations.

Because of all those risks, investors around the world are investing in long-term bonds. They pay about 4% per year in interest, and they're much safer than any of these other investments.

This view, which Greenspan other high-priced analysts refuse to utter, is quite consistent with other data. An article in today's (June 8) Wall Street Journal says that manufacturing growth is slowing around the world. According to the article,

"Virtually across the world, the rate of growth is decelerating in manufacturing," says Daniel Meckstroth, chief economist with Manufacturers Alliance/MAPI, a public-policy group in Arlington, Va. ...

This year, U.S. industrial production is expected to rise 3.7%, slower than the 4.1% growth of last year. Germany is expected to slow to growth of 1.9% from 2.4%, while Italy is forecast to record a decline of 0.5%, compared with a fall of 0.7% in 2004. The drop-off is even more pronounced in parts of Asia, with industrial-production growth slipping to 1.4% in Japan from 5.2%, to 7.5% in Malaysia from 12.6%, and to 6.3% in Singapore from 13.9%. Export-oriented Asian economies such as Malaysia depend heavily on Japan to soak up their goods and are getting hammered by its slowdown. China is expected to decelerate modestly, to 14% from 16.7%, although past predictions about Chinese slowdowns haven't materialized."

So, the worldwide fall in long-term interest rates coincides quite naturally with the worldwide slowdown in manufacturing growth. Manufacturing isn't doing well, so investors put their money into long-term bonds rather than manufacturing plants, raising the price of bonds, and lowering yields (interest rates).

A recent article entitled, "Alan Greenspan warns that global economic dangers are without historical precedent," describes how Alan Greenspan reversed his long-held position on the health of the world economy. Generational Dynamics predicts that things are going to get much worse. (8-Jun-05) Permanent Link
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Generational Dynamics Web Log for 8-Jun-05 Alan Greenspan predicts major losses by hedge funds

Why is the yield curve flattening?

Generational Dynamics view

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Generational Dynamics Web Log for 8-Jun-05
Alan Greenspan predicts major losses by hedge funds