If there is really a financial recovery on the way, someone forgot to tell the corporate bond market. U.S. Treasury Secretary Timothy Geithner's plan to rescue the financial system sent the S&P 500 soaring 7% on Monday alone, bringing its gains from its lowest point on March 6 to an impressive 21%. But credit markets have hardly budged.

Corporate debt is still priced for disaster. Investment-grade nonfinancial U.S. corporate bonds rallied in January but have now stalled, with spreads around four percentage points over Treasurys, Markit iBoxx indices show. More worryingly, even as bank stocks have climbed, with the KBW index gaining 54% from its lows, U.S. senior bank bond spreads remain at their widest levels since Lehman Brothers collapsed.

Bonds are pricing in unheard of and devastating levels of default. Deutsche Bank recently calculated dollar investment-grade corporate bonds were pricing in a five-year default rate of 40% assuming average recovery rates. Even if one makes the unlikely assumption that bondholders recover nothing after default, prices suggest a 25% default rate over five years. The worst five-year investment-grade default rate since 1970 is just 2.4%. The average is 0.9%.

On that basis corporate debt is almost absurdly cheap — and so a lot of investors are pumping money into the market. That this has failed to fuel a rally in the credit markets similar to that in equities should ring warning bells for stock market investors. What is holding back the credit markets is a lack of demand for financial debt — a sure sign that all is still not well in the banking system.

Demand in the credit markets is mostly for nonfinancial debt, but this is being met by huge supply as borrowers look to bypass the banking system, thereby preventing spreads from tightening. The vast majority of financial debt finding buyers is that guaranteed by governments — hardly a vote of confidence. Asset-backed securities and leveraged loans remain unloved.

Until investors recover confidence in financial assets, credit spreads are unlikely to tighten significantly. And without a sustained improvement in the credit market — the seat of the crisis — it seems irrational to expect a durable move higher in equities.

NEW YORK (Reuters) – Bridgewater Associates Inc, one of the world's biggest hedge-fund managers, said on Tuesday it might be interested in participating in the U.S. Treasury's public-private investment program, calling it a "big transfer of money from the government to the banks and to the buyers."

Bridgewater manages roughly $80 billion in global investments for a wide array of institutional clients, including foreign governments and central banks.

In a letter to clients, Bridgewater said its interest in buying the distressed assets under the terms being offered would depend on the pricing and on "whether we can get over our fears of partnering with the government."

Last week's political furor surrounding the American International Group Inc bonus payments raised the risks for private capital firms thinking about partnering with the Treasury. Many have expressed reservations regarding retroactive curbs on compensation and profits.

But investors' concerns were muted after Federal Reserve Chairman's Ben Bernanke's statement to a congressional hearing on Tuesday in which he said: "I do think we have to provide assurances to participants" in the Term Asset-Backed Securities Loan Facility and the Public-Private Investment Fund, for example, "that their involvement will not be retroactively penalized in some way."

Ray Dalio, the founder of Bridgewater, is considered one of the world's most successful investors. Bridgewater's Pure Alpha fund returned 8.68 percent last year, according to Absolute Return magazine, while many hedge funds posted double-digit losses for the same period.

In August 2007 when markets were in near free-fall, Bernanke held discussions with financial experts, including Dalio.

In the letter, Bridgewater said: "From a macro perspective, this is a big transfer of money from the government to the banks (who are getting the higher prices for their assets) and to the buyers (who are probably going to get a heck of a deal because of the non-recourse loan and the easy access to leverage).

"If the government was operating in an economic way, it would not do this deal — it would deal with the banks' finances separately and sell this insurance (i.e. the implied put arising from the non-recourse loan) for what it's worth," Bridgewater said in the letter.

"But, politics being what they are, this route is probably motivating this non-economic behavior. We are eager to see how it is received on the Hill," it said.

China and the Dollar

As if the dollar didn’t have enough problems, Timothy Geithner took China’s bait yesterday and said he was “quite open” to its suggestion this week to displace the greenback with an “international reserve currency.” The dollar promptly fell and stocks followed, before the Treasury Secretary re-emerged to say “the dollar remains the world’s dominant reserve currency. I think that’s likely to continue for a long time.”

Mr. Geithner is learning on the job, and yesterday’s lesson is that it isn’t smart to fool with currency markets when you are already tempting fate with a gigantic U.S. reflation. Treasury and the Federal Reserve are flooding the world with dollars to break the recession, and the world is rightly getting nervous. The solution floated by Chinese central bank governor Zhou Xiaochuan — an increased role for the International Monetary Fund — isn’t desirable. But his warning about the dangers of dollar weakness and exchange-rate instability is still worth heeding.

Since the collapse of Bretton Woods in 1971, the global economy has tried to function with floating exchange rates, in which the “market” is said to set currency prices. As the world discovered in the 1970s and the Bush Treasury forgot, however, the market for currencies isn’t the same as for apples or copper. Central banks control the supply of currencies through their monopoly on money creation. Often, as at the Alan Greenspan-Ben Bernanke-Donald Kohn Federal Reserve this decade, they get policy wrong, with disastrous consequences. Amid the global economic downturn, some central banks, like Vietnam’s, are also turning to currency devaluation for a trade advantage.

Mr. Zhou may want to head off this potential train wreck. On Monday he proposed an international reserve currency “anchored to a stable benchmark and issued according to a clear set of rules.” He wants the supply of money to allow for “timely adjustment” to “changing demand,” and those adjustments to be “disconnected from economic conditions and sovereign interests of any single country.” And he thinks the IMF can create a global currency by expanding the use of its already-existing Special Drawing Rights (SDRs), a synthetic currency linked to the underlying currencies of IMF states.

Yet who would determine the “right price” of the SDR — the IMF? The multilateral institution’s economic prescriptions have sent numerous nations into tailspins, particularly in Asia. There’s nothing to say, too, that national monetary authorities wouldn’t cheat and adjust their domestic money supplies as they saw fit — or apply political pressure on the IMF to change the SDR’s currency weightings in their favor.

But the main problem with the SDR is that it can’t be used for anything in the real world. When the IMF allocates SDRs, recipient countries exchange them for local currencies at local central banks. That money is then used to buy real assets and facilitate trade. That exchange inflates the money supply of the domestic country that’s accepting the SDRs in exchange for local currency.

There isn’t consensus within China’s central bank on the idea of empowering the IMF, though Beijing is eager to have more say at the institution. Hu Xiaolian, a vice governor of the bank, said Monday that “investing in U.S. Treasury bonds is an important component of China’s foreign currency reserve investments.” She added: “We are naturally relatively concerned with the safety and profitability of U.S. government bonds.”

Ms. Hu isn’t alone, and we only wish the Treasury, the White House and the Fed were equally as concerned. The dollar’s status as a reserve currency gives the U.S. enormous advantages, and it should be protected ferociously by our public officials. It means we don’t have to repay our debts in foreign currency and that our borrowing costs are cheaper. To the extent that the rest of the world follows a dollar standard, it also gives us far greater global sway.

It is this influence that Russia, China and others sometimes resent and would like to see displaced. The problem is that there really isn’t an obvious successor to the dollar. No other economy is large enough, with deep enough capital markets. The euro might become an alternative down the road, but it remains too new and lacks the necessary underpinning of political cohesion.

Yet Mr. Zhou’s demarche is also a warning that reserve currency status carries special obligations. It means the U.S. isn’t conducting monetary policy only for itself but for much of the world. And it means that when the U.S. falls for the temptation to debase its currency, it sends shocks through the entire global trading system. The dollar’s sharp but needless gyrations during this decade are in our view one of the major causes of the housing and commodity asset bubbles that led to the financial panic and global recession.

If Mr. Geithner meant yesterday that he is “open” to broader monetary and exchange-rate cooperation, that could be a step forward. But instead of abdicating to IMF bureaucrats, this would mean working with the world’s most important governments and central banks — for starters, the Fed, ECB, and the Banks of England, Japan and China. The world could use monetary reform, but the goal should be to reduce currency fluctuations and enhance price stability and world trade. In the meantime, the dollar’s special status is an asset worth preserving.

Calpers, the California public pension fund that is one of the biggest investors in hedge funds, is demanding better terms from funds, including lower prices and “clawbacks” of fees if performance weakens.

The $172 billion pension fund is a bellwether in the money-management business. A Calpers investment can help money managers like hedge funds attract other clients.

The move by the California Public Employees’ Retirement System underscores the changing dynamics between hedge funds and their clients. Just two years ago, investors clamored to get into highflying funds, agreeing to pay fees that in some cases reached 3% of assets and 30% of profits. Lately, hedge funds have come under fire for failing to live up to their promise to perform in good and bad markets.

While other investors are pushing for fee cuts, Calpers, which has $5.9 billion in hedge-fund investments, holds significant clout. “Calpers is the 800-pound gorilla, pushing so much money through the system,” said Eric Roper, chairman of the hedge-fund practice at New York law firm Gersten Savage LLP.

Calpers’s demands were outlined in a March 11 memo sent to the 26 hedge funds and nine funds of hedge funds that do business with Calpers; it was reviewed by The Wall Street Journal.

Some of the hedge funds that manage Calpers money include Tremblant Capital, Atticus Capital and Och-Ziff Capital Management, according to Calpers records and people familiar with the investments. Spokesmen for the funds didn’t comment.

Besides pressure on fees, hedge funds are likely to face closer scrutiny from regulators, threats of higher taxes and more constraints on their trading strategies, after a year of broad-based losses.

Calpers said the changes are “extremely important” and required of “managers wishing to become, or remain” in Calpers’s stable of managers. The pension fund said every hedge fund won’t face the same demands and that it is willing to listen to counterproposals.

One area Calpers is focusing on includes performance fees. Typically they are collected at the end of each year, but Calpers instead wants fees spread out over several years. Calpers also wants clawbacks, which allow clients to recoup fees from previous profitable years after a period of poor performance.

The pension fund also seeks greater control of its investment funds, saying it would explore opening managed accounts. In that scenario, hedge funds would place Calpers’s assets in a separate bucket from other investors’ assets, so if a fund faces an exodus of investors and sought to freeze redemptions, Calpers wouldn’t be limited from withdrawing its funds.

Calpers also wants money managers to disclose every security held in a fund. “The only issue that keeps hedge funds from providing security transparency is their lack of cooperation,” Calpers spokeswoman Pat Macht said in an interview Friday. She said that detailed fund information won’t be made public.

Calpers is basically trying to wield its investment clout to shape its relationship with hedge funds. The memo says Calpers “will no longer invest in managers” that adhere to industry standards with no regard for individual situations. At the same time, Calpers bills the directives as good for hedge funds as well as for institutional investors — a means to “improving the relationship” for the long term.

The sought-after changes would apply to new money added to existing funds and money put into new hedge funds, and will take about a year to implement, Calpers said. None of its hedge funds have formally agreed to the new terms, though discussions have started with most and cooperation appears to be widespread, Ms. Macht says.

Calpers’s demands come as other institutional investors are issuing similar requests in an effort to upend industry protocols. In January, the Utah Retirement Systems circulated a four-page letter to 40 hedge fund managers, and to many like-minded investors, that called for similar changes.

“We clearly are on the same page with regards to most issues,” said Larry Powell, deputy chief investment officer for the Utah fund, referring to the Calpers memo.