Hedge funds lose their tail wind

WHEN the Federal Reserve Board reversed the trend of interest rate movement in 1994, it wrong-footed almost every investment bank and trader in the country and cost them billions of dollars.

Today all the pundits say that Alan Greenspan, the Fed's chairman, will again reverse policy, and American interest rates - which were cut to 1% to help ward off recession in the aftermath of the dotcom bubble - will begin their long climb back to more normal levels. Unlike 1994, every effort has been made to prepare the market for what is coming. If anyone is caught by surprise, they should not be in the market.

But the rise in rates will still have a fundamental impact even if it is widely expected, for the price of money is a benchmark for the attractiveness of all other investments. Thus it was that in the US from 1966 to 1982, the Dow Jones Average of leading shares rose not at all because interest rates were going up remorselessly.

From 1982 to 2000, that same Dow rose eleven-fold. The big companies in the Fortune 500 index were growing their earnings more slowly than in the first period but the decline in interest rates from the 20% peak of 1982 powered the market upwards.

The big question now is how hedge funds, which have been the investment phenomenon of our time, will cope with the changed environment. Some are already feeling the squeeze and have found it hard to make positive returns in recent weeks as markets reposition themselves for today's expected announcement.

But the real test is still to come because, in the words of one seasoned industry veteran, hedge funds have been operating for some years with the favourable tail wind of declining interest rates, and that has led many to attribute their growth to brilliance rather than a bull market. Making the same level of returns when interest rates are trending upwards presents a much stiffer test.

Chicago's message

ANOTHER to be rubbing his hands as Alan Greenspan puts up US interest rates is Bernie Dan, chief executive of the Chicago Board of Trade (CBOT), who is in town for International Derivatives Week, an event shrewdly timed to coincide with-Wimbledon.

The CBOT's strength is its contract in US Treasury bonds, which allows people to insure themselves against interest rate movements. With interest rates rising and inflation back on the agenda for the first time in years, the number of organisations seeking to use this contract for hedging is likely to soar.

Dan's few years at the CBOT have been a remarkable success story. He took over an exchange that was losing money, had a membership reluctant to embrace electronic trading, had a high cost base and faced competition from Eurex, the Swiss-German Exchange that had overtaken it as the world's largest futures market.

Things today look a lot more cheerful. Switching to Liffe Connect technology, the electronic trading software developed in London, enabled major cost cuts and a huge expansion in the quality and range of services. Driven by this, the exchange transformed itself from laggard to leader and made over $100m (£55m) profit last year.

The competition from Eurex, which opened in Chicago this year, has been met with price reductions, rationalisation of clearing infrastructure, better technology and an expanding suite of products. The result is that the Europeans have barely laid a glove on the incumbent exchange, none of the liquidity has moved from its key contracts to Eurex and the newcomer has had to offer its service free as a marketing ploy to drum up business.

Despite the price cuts, CBOT profits are setting new records, driven by a surge in volume that has seen the number of contracts traded rise from 325,000 in 2002 to 700m this year, with 1bn the target for 2006.

The significance for London, and for the rest of Europe, is that if last year was about transition, this year is about growing the market. CBOT is developing hubs in places like Gibraltar and Dubai, which Dan sees as sources of trading capital where there is a latent but logical interest in trading American futures.

But his real message for London - and indeed for the London Stock exchange, which is rapidly becoming a minnow in shark-infested waters - is that borders become irrelevant if an exchange has the technology, the products and the freedom to plug in customers.

His other message is that there is no future in being a one-asset-class exchange, which is what London is. He thinks the future lies in the structure developed by Deutsche B?rse and EuroNext offering a huge range of products in a huge range of markets and becoming in effect financial services companies.