I haven’t worked in a traditional office in a long time. I miss some of the camaraderie, the ability to bounce ideas around, and the occasional happy hour. But I don’t miss some of the personnel issues that pop up, like friction among co-workers, bad-smelling lunches wafting through the office, and the annual Secret Santa.

I’m not a Scrooge by any stretch. Christmas is my favorite time of year. But forced gift giving always had a bad vibe. In big offices, those participating often cut straight to the chase. Under things they wanted, they simply listed “gift card.” Awesome.

If you’re like me, then I’ve got bad news for you. In the world of finance, you’re the Secret Santa, and hedge funds are the gift recipients. You’ve been forced to give them gifts for almost a decade. When you stopped giving in September, it sent the credit markets into a tizzy, so the Fed dipped into your pocket and made you give some more.

It’s all about repos.

The term “hedge fund” hasn’t meant a fund that only makes hedged investments for a long time. We use the term very loosely to apply to private capital firms and those that only take accredited investors. They come in all shapes and sizes, but many of them have one thing in common: They use borrowed money, or leverage, to turbo charge their returns.

If a fund has $100 million to invest and earns 8%, then it earned $8 million. Not bad. If the same fund borrows an additional $40 million and makes 8%, then the fund earned $11.2 million. That’s better. The fund has to pay for borrowing in the form of an interest rate, which is where we come in.

To borrow the cheapest money possible, hedge funds and others that run leveraged (or levered, as it’s called) portfolios borrow money on a very short-term basis. As in, overnight. This drives their interest cost close to the Fed Funds rate. They simply re-borrow, or perpetually borrow, every day with a one-day maturity.

Recently, these funds were paying 2% to borrow overnight. If the fund in the above example paid that price, it would be $800,000. Netted against the $11.2 million gain, the fund would have earned $10.4 million on a principal balance of $100 million, for a 10.4% gain. That’s a lot better than 8%!

But someone has to lend the funds the money. That’s where you and I come in as unwilling lenders.

Typically, the money comes from banks that use their excess reserves, the amount of money they have in excess of what’s required by the Fed. The banks built up huge excess reserves as the Fed printed money and bought bonds from 2009 through 2015. This created a big pool from which hedge funds could borrow at rock-bottom rates.

While we earned near zero on our deposits and fixed income thanks to the Fed, hedge funds have been able to borrow for a song and goose their returns in the equity markets. The process distorts the fixed income market because the Fed crams down rates, and distorts the equity markets by providing almost free cash that hedge funds use to drive up equity prices.

The entire process creates weird financial bubbles, as I outlined in the December issue of Boom & Bust.

But like all parties, this one came to an end in September… at least for a moment.

The banks that had been lending reached a threshold in their excess reserves and weren’t willing to lend anymore. The hedge funds panicked and bid up the cost of borrowing to 10%. They needed the money to make good on trades.

You’d think this would be a good thing. If the hedge funds want to borrow to invest, they should pay for the privilege, and it should be at miniscule rates. But the Fed was having none of it. They want the party to last forever, so they did what they know how to do, and started buying bonds again. Since September, the Fed has pumped about $200 billion into the market, buying up Treasury bonds and making cash available to hedge funds so they can keep driving up equities.

As for you and me, we’re the ones footing the bill in the form of paltry earnings on our savings and below-inflation interest rates on 10-year bonds.

We do get to piggyback on the hedge funds as they push the equity markets higher, but that won’t be much comfort when the bubble finally busts and prices fall in line with economic growth, which are two scenarios Harry’s been predicting. By that time, many of the hedge fund guys will have cashed a bunch of bonus checks and be spending time in the Hamptons.

Chances are, they won’t even send us a thank you card.

New Update on the Markets!

Harry Dent shares details on his latest prediction for the markets and the new dangers that lie just ahead for Americans:   “This is no longer a question of ‘if,’ but simply a… Read More>>
Rodney Johnson
Rodney works closely with Harry to study the purchasing power of people as they move through predictable stages of life, how that purchasing power drives our economy and how readers can use this information to invest successfully in the markets. Each month Rodney Johnson works with Harry Dent to uncover the next profitable investment based on demographic and cyclical trends in their flagship newsletter Boom & Bust. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. Along with Boom & Bust, Rodney is also the executive editor of our new service, Fortune Hunter and our Dent Cornerstone Portfolio.