Investors Bullish on Fed Tips

By SUSAN PULLIAM

Hours after an Aug. 15 meeting with Federal Reserve Chairman Ben Bernanke in his office, Nancy Lazar made a hasty call to investor clients: The Fed was dusting off an obscure 1960s-era strategy known as Operation Twist.


Meetings held by Ben Bernanke, left, and William Dudley

The news pointed to a boom in long-term bonds.
It was a good call. Over the next five weeks, prices on 10-year Treasury bonds soared, offering double-digit returns in an otherwise dismal year.
By the time the Fed announced its $400 billion Operation Twist on Sept. 21, the window for quick profits had all but slammed shut.
Ms. Lazar is among a group of well-connected investors and analysts with access to top Federal Reserve officials who give them a chance at early clues to the central bank's next policy moves, according to interviews and hundreds of pages of documents obtained by The Wall Street Journal through open records searches. Ms. Lazar, an economist with International Strategy & Investment Group Inc., wouldn't comment for this article.

The access is part of a push by hedge funds and other traders to get more information about the inner workings of government. Developments in Washington have become more important after the financial crisis in 2008 spawned new regulations and a stronger hand by lawmakers in businesses.

Capital Gains

Hedge Funds Pay Top Dollar for Washington Intelligence (10/4/2011)
Read More

New Supply of Former Fed Officials Finds High Demand on Wall Street
Higher 'Stress' for Big Banks
The words and actions of the Federal Reserve, in particular, have an enormous impact on markets, prompting the creation of new guidelines at the central bank to combat the perception of favoritism.

Conversations are important to both sides, making it difficult for the Fed to completely close its doors to traders and analysts. Fed officials want to know how investors might respond to changes in monetary policy and to avoid surprising markets. Investors, meanwhile, reveal developments that might pose unseen dangers to the U.S. economy, say people familiar with the matter.

Such talks are perfectly legal but create a delicate dance for the Fed, which tries to sate its need for information to help guide monetary policy without giving Wall Street an unfair advantage over Main Street.

Mr. Bernanke discusses only matters already public, a spokeswoman said. But hedge fund managers and Wall Street executives who meet regularly with him and other Fed officials—both in his office and through advisory committees—say they get valuable insights during the face-to-face talks.

"It's like an inquisition, they have a topic," said Laurence Fink, chief executive of investment-management giant BlackRock Inc. "By the questions they ask, by definition, you know what's on their mind."


Mr. Fink had phone calls and meetings with Fed officials ten times over the past two-and-a-half years, according to their calendars and open records requests. He said most of the conversations related to BlackRock's role as a paid adviser to the New York Fed about complex financial structures formed during the financial crisis.

New York Federal Reserve Bank President William Dudley also meets regularly with investors, both in his office with individuals and in committee groups. The New York Fed, one of 12 regional banks that constitute the Federal Reserve System, has the strongest ties to investors because it conducts the Fed's bond-market transactions.

Mr. Dudley, who also is vice chairman of the Federal Open Market Committee, which sets the nation's monetary policy, acknowledged the discussions could give the misperception that investors with access to Fed officials have an advantage.

"We take great care to frame subjects and questions in a neutral manner that does not provide any insight into our own thinking and we are careful to keep in mind that their comments may sometimes reflect their firms' own interests," Mr. Dudley said in a statement.

The meetings are "particularly important during periods of market stress," he said, and help him get a "broad range of perspectives on the markets and the outlook for the economy."

View Interactive

Over the past two-and-a-half years, Mr. Dudley has had dozens of private meetings, according to his calendar, which lists SAC Capital Advisors, Citadel Investment Group, Duquesne Capital Management, and Tudor Investments, among others. Lloyd Blankfein, chief of Goldman Sachs Group Inc., and Mr. Fink, of BlackRock, also had private meetings, according to Mr. Dudley's calendar.

These investors employ strategies tied to interest-rate policy and economic trends—making snippets of information as subtle as head nods and body language extremely valuable.

There are central bank rules that bar officials from discussing confidential Fed actions not yet public. But gleaning clues about the thinking of Fed officials during private talks can be as valuable to investors making bets on the direction of the economy.

Worries about Fed access surfaced a year ago. On Aug. 18, 2010, former Fed governor Laurence Meyer, who runs a research service predicting and analyzing Fed actions, told clients in a note the central bank's "bazooka is loaded" to buy bonds to stimulate the economy.

The note described how the Fed's "doves," members inclined to ease monetary policy, had said the Fed couldn't "sit on its hands," according to Mr. Meyer's account. An Aug. 20 note included some specific information about the Fed's balance sheet.

A week later, Mr. Bernanke said during a speech in Jackson Hole, Wyo., that "policy options are available to provide additional stimulus" to the economy. Stocks rose on the news, which by then had given Mr. Meyer's clients plenty of time to profit.


From Mr. Dudley's calendar.

The Fed announced its move in November—a second, so-called quantitative easing plan, known as QE2, that entailed buying $600 billion worth of long-term Treasurys.

At its Jan. 25, 2011, meeting, Fed members weighed the need for communications as part of the "monetary policy transmission process" against the "fair and equal access" that should be offered to the public, according to minutes of the meeting. Fed members asked a subcommittee to consider better guidance to Fed members on communicating with investors.

A new set of guidelines was approved in June. It said Fed members should "to the fullest extent possible" avoid meeting privately with "any individual, firm, or organization who could profit financially from acquiring" information from the Fed "unless those views have already been expressed in their public communications." In October, the New York Fed stopped providing early access of its economic forecasts to Wall Street analysts serving on a Fed advisory committee.

The new rules didn't keep Ms. Lazar and others from alerting clients to Operation Twist. Richard Tang, bond-trading chief at Royal Bank of Scotland and a member of the Treasury Borrowing Advisory Committee, made a similar forecast about a week before Ms. Lazar. Through his committee membership, Mr. Tang meets several times a year with Treasury Department and Fed officials, including Mr. Bernanke.

Jan Hatzius, chief economist at Goldman Sachs, was also ahead of the pack, telling clients on Aug. 9 that he believed another round of bond buying by the Fed was coming. Mr. Hatzius is a regular guest of Mr. Bernanke and he meets privately with Mr. Dudley—his former boss at Goldman—according to calendar records.

Enlarge Image

From Mr. Bernanke's calendar.

Mr. Bernanke in a widely anticipated Aug. 26 speech in Jackson Hole, Wyo., left open the possibility of action to boost the economy but didn't say what the Fed might do or when.

Rumors of Operation Twist spread, working in the Fed's favor. The possibility of the central bank buying long-term Treasurys, along with troubles in the world economy, spurred investors to buy them first. The subsequent rally pushed up prices and dropped yields, which move in the opposite direction. Investors, in effect, helped Fed efforts to lower borrowing costs.

"Some may claim for self-interested reasons to have special access to Fed thinking," a Fed spokesman said. "You should take all such claims with a heavy dose of skepticism. Fed thinking is the source of frequent and extensive speculation, much of which, even by prominent 'Fed watchers', is often and substantively wrong."

Until the mid-1990s, the Fed didn't even announce policy changes, which were signaled only by the manner and time of day that Fed traders intervened in money markets.

In the years since, the central bank instituted policy announcements, along with statements to explain decisions under Mr. Bernanke's predecessor, Alan Greenspan. Mr. Bernanke initiated news conferences this year, which Mr. Greenspan never did.

When Treasury Secretary Timothy Geithner was president of the New York Fed beginning in 2003, he worried the Fed wasn't close enough to big investors, especially financial firms like hedge funds that operated outside of the regulated banking industry. He set up a new staff position to coordinate private meetings with hedge fund managers and other Wall Street power brokers.

After the financial crisis, Mr. Dudley, who followed Mr. Geithner as New York Fed president in January 2009, went further. Concerned about the growing role of hedge funds and investment banks in a so-called shadow banking system, he established the Investor Advisory Committee on Financial Markets to open a pipeline into the thinking of big investors.

The relationship also drew these investors closer to Fed thinking. As winter turned to spring this year, discussions centered on the Fed's fading optimism and gave an early view of where the central bank was heading, according to agendas and minutes from committee meetings obtained through open records requests by the Journal.

The pace of the U.S. economic recovery picked up speed at the end of 2010, and the stock market gained nearly 10% in the first four months of 2011. A run-up in commodity prices had raised inflation fears, triggering talk about an exit from the Fed's support of historically low rates.

But an early sign of trouble came May 10 to members of the New York Fed's Economic Advisory Panel, who meet twice a year with Mr. Dudley. They received a 37-page economic forecast by staff economists at the New York Fed that concluded, "Clearly the economy faces some new headwinds that were not present in early November." The document included data and charts detailing the slowdown, according to a copy obtained in an open records search.

The message was clear. The U.S. economy, which weeks earlier looked like it was recovering, appeared to be slowing, according to New York Fed economists. By contrast, Mr. Dudley was more positive at a May 6 news conference, emphasizing the view that recent weakness in the economy wouldn't last.

For big investors, the accuracy of the New York Fed prediction was less important than the view it represented: If the broader Fed committee also anticipated a slowdown rather than growth, it would lean toward keeping interest rates low or take action to stimulate the economy, rather than raising rates to fend off inflation.

On May 25, the Investor Advisory Committee on Financial Markets held a conference call to discuss the agenda of its June 9 meeting. Talk shifted from the Fed's exit strategy, a main topic at its December meeting, to worries about the economy.

In a June 5 note to clients, Mr. Hatzius expressed renewed confidence in his long-standing view the Fed would keep rates near zero until 2013. "In fact," he wrote, "organic growth seems to have slowed anew to a below trend pace in the first half of 2011."

During the summer, investors grew more nervous over the softening economy, building stress in Europe and the downgrade of U.S. government debt.

Stocks were reeling after the Fed issued its Aug. 9 post-meeting statement with news that indeed it wouldn't raise rates until mid-2013, a position based on a gloomy view of the U.S. economy. At one point, the Dow Jones Industrial Average sank 205 points, about 2%.

The last paragraph of the statement said the Fed was ready to employ "the range of policy tools available." Some analysts correctly predicted the line signaled a new round of bond purchases, a dramatic turnaround from the conventional view only weeks earlier. As the more sanguine interpretation spread, stocks soared, closing up 4% for the day.

Among those who got the word out was Mr. Tang, who told clients that afternoon the Fed would purchase longer-term bonds, according to people familiar with the matter. The strategy, now known as Operation Twist, would shift a portion of the Fed's portfolio from short-term bonds into long-term bonds.

"Can't afford to miss this move," he told clients in an Aug. 17 email.


http://online.wsj.com/article/SB10001424052970204554204577025922155198762.html?mod=WSJEUROPE_hps_LEFTTopWhatNews