Rate Cut Scorecard

Adam Hamilton    June 29, 2001    3897 Words


After a wild and memorable market ride in the first six months of 2001, we find ourselves perched on a high mountain pass straddling the first and second half of the year.  From our halftime vantage point we can gaze out into the hazy market future, wondering what tidings it will bear. 


What will transpire in the economy in the next six months?  Will the markets execute their long awaited and prophesied assault on the heavens?  Will the bears be right and we all find out that fundamentals still do matter in our strange “New Era”?  Whatever actually comes to pass in the bottom half of 2001, we are certain it will not fail to amaze and astound at times, encourage or discourage at others, and generally keep everyone guessing, bull and bear alike.


As we find ourselves on the temporal summit dividing the first and second half of 2001, it is also a very appropriate time to look back and reflect on the last 180 days.  So incredibly much has happened in so many diverse markets that it is challenging to decide where to start looking for market highlights.  We do believe though, that when financial historians and economists look back on the first half of 2001, that a single series of events will leap out and demand attention…


Greenspan’s ultra-aggressive interest rate cuts.


The Greenspan Fed, under the “Maestro” himself, has embarked on an unprecedented course in the aggressiveness of its interest rate slashing.  Six cuts have been made in six short months, five of them deep, the most recent superficial.  Two of these cuts were deemed so critical that the Federal Reserve could not even wait a mere few weeks until the next scheduled meeting!  There have been past easing cycles in history that have lopped off more than this one’s 275 basis points, but for speed and intensity the Greenspan Gambit of H1 2001 certainly takes the title.  Greenspan’s six rapid-fire machine gun interest rate cuts will forever be the hallmark of these six chaotic and exciting market months from which we have all just emerged.


As in any great football game, halftime is when everyone can take a breather, look back on the first half, and examine the score.  To analyze the score on the interest rate cuts, we decided to appropriate the vantage point of Greenspan and his Fed. 


While we believe that the US equity markets remain grossly overvalued and that history teaches a mean reversion to normal valuations is inevitable, we and other bears are still in the tiny minority.  The legions and legions of equity bulls, on the other hand, make up the largest constituency on Wall Street and many believe that markets can go up forever because they have subscribed to the hype that we have entered a brave “New Era”. 


When Greenspan initially pulled the trigger on his first emergency rate cut, the bullish cacophony emerging from Wall Street and the financial press was simply deafening.  We all heard, over and over and over again, that interest rate cuts ALWAYS push the equity markets higher.  Everyone who is interested in the financial markets and lives in the first world certainly remembers those bullish cries of victory over the business cycle, so there is no need to elaborate further here.


Six months later, it is appropriate to look back and see what the rate cuts have accomplished thus far in their mission to save the US equity markets.


We chose 16 important financial variables to briefly analyze how they have performed in the first half of 2001 during the Fantastic Greenspan Rate-Cutorama.  Some of these variables the Fed can exert quite a bit of influence over, while in others it has none.  In this essay we will briefly comment on each of the variables and offer some thoughts on whether the change can be seen as a victory or defeat through the eyes of the Fed.


The following table holds our 16 financial measurement variables.  The “Before” column has data taken from late December.  Most of this data was taken on the last trading day of December, the 29th, but some variables such as the money supply are not published every day so a data date was chosen as close as possible preceding the last trading day of 2000.  The “After” column shows the variables as of market close on June 27th, the day of the sixth Fed rate cut.


It would not be hard to argue that data from June 29th, the last day of the first half, may be better for comparisons, but we instead chose to use data from the day of the Fed’s latest rate cut for a couple reasons.  First, the last few days of a quarter almost always witness anomalous and non-representative trading as the battalions of professional money managers buy and sell aggressively to provide “window dressing” for their shareholders.  They make sure their holdings are exactly the way they want them because those positions will be reported to their clients in their quarterly mutual fund statements.  By using data from the 27th, we hoped to filter out some of the funny end of quarter trading patterns.


Second, with potentially market-moving events like the Microsoft ruling and GDP numbers rapidly eclipsing the Fed’s 25 basis point move into the background, it seems prudent to take the market close the day of the rate cut for comparison purposes at the moment.  The BEST possible comparisons will not be possible until a year or so after the Fed acts, but until the future arrives this is all the data we have.


The “Delta” column shows the percentage change from late December until late June, which encompasses all six of Greenspan’s interest rate cuts.  The “Annual” column shows the respective percentage changes annualized, what the rate of change would end up being if maintained over a whole year.  Finally, in the fine spirit of sport, the “W/L” column shows whether we think the change will be viewed as a win or a loss FROM THE PERSPECTIVE OF THE FEDERAL RESERVE.  In addition, if the “Delta” is shaded yellow, it means we think that particular variable is a BIG loss for the Fed.


Without further ado, we offer the 2001 Halftime Fed Rate Cut Scorecard!   



On the short-term interest rate front, the Fed’s short-term rate cuts probably had the exact intended effect.  The 3 month Treasury bill yield plunged 38% and the one year T-bill yield shed 32%.  The Fed certainly achieved its goal of lowering short-term debt costs.  We assign two wins to Greenspan and his Fed on the short-term rate results.


Unfortunately for the average American investor, however, lower short-term rates don’t do much good and may do substantial harm.  Lower short-term interest rates do not lower the cost of credit cards materially (most have high minimum rate floors) or lower the cost of paying for a house.  On the contrary, the low rates eviscerate the yields of money market funds which typically invest heavily in short-term debt instruments.  By lowering money market yields, Greenspan achieved the probably well-planned side “benefit” of forcing investors back into the extremely risky equity markets since there was no longer any money to be made in money market funds.  The bombing of money market yields, CD rates of return, and other near-cash investments provides a huge DISincentive for saving.  Nevertheless, the Fed appears to have achieved their goals in short-term interest rates.  Score Greenspan two, “market forces” zero.


What are the “market forces” we pit Greenspan against, you wonder?  The bizarre idea that one man and a committee he dominates can arbitrarily set the price and quantity of money by regulatory fiat in our complex FREE MARKET economy is pretty archaic and silly.  It is amazing that more people do not perceive this glaring contradiction to free market capitalism.  In the old Soviet Union, bureaucrats would sit in ivory towers and dictate the price of everything, from sausages to money to industrial equipment.  And how did that particular command-and-control experiment turn out?  Not very well, to say the least.


What if, instead of unilaterally setting money prices (interest rates) by fiat, Greenspan was given the task of divining the price of tennis shoes by decree?  What if his committee of elite bankers decided that tennis shoes all over the US should only be sold at a fixed price?  Wouldn’t that be goofy?  Pick any market good or service you want and imagine a committee of central bankers sitting in smoke-filled rooms regulating its price by decree and trying to outguess the free market and you get an idea of how far-fetched this concept of money by committee really is. 


Because the price and quantity of money in a FREE MARKET should be “set” by Adam Smith’s “invisible hand” of free market capitalism, we think Greenspan is fighting market forces as his opponents.  Unless you are unfortunate enough to call Cuba or China home, central planning went out with all the rest of Karl Marx’s poisonous baloney when the Soviet Union collapsed.


While the Greenspan Fed crushed short-term interest rates like NATO bombers decimating small backwater supposedly sovereign nations, the Fed was brutally repelled by free market forces on the long end of the yield curve.  The long bond yield actually ROSE slightly over the ultra-aggressive easing period, spitting in the eyes of the FOMC central planners.  We are sure this annoys Greenspan to no end that the massive bond market does not believe his hype that bubblevision gullibly swallows hook, line, and sinker.


Even worse than its stinging defeat at the hands of the “bond vigilantes”, however, the Fed’s most devastating failure of the entire six months was the absolute, total, complete, unequivocal, overwhelming lack of impact the rate cutting circus had on 30 year mortgage rates.  They were unchanged after six aggressive Fed rate cuts, defying pressure to conform.


As the bulls and bears know, the US consumer directly or indirectly accounts for 2/3 of the total US economy.  If the consumer is to have cash to spend that will flow into corporate coffers and re-ignite evaporating profits, the consumer desperately needs some debt relief.  For virtually every hard-working American consumer, the single biggest drag on income each month is mortgage debt service.  We strongly believe that the Fed had an original strategic goal before it began slashing interest rates of knocking mortgage costs down to give the consumer some breathing room.  Unfortunately, for both the Fed and the consumer, the monolithic long mortgage market has not even blinked after Greenspan’s amorous advances.  The Fed is slamming its head against the mortgage wall with reckless abandon, but it refuses to budge or even shake.


For its overwhelming lack of progress on long-term interest rates, we give the Fed two big fat losses because of its frightening inability to influence these critical markets.  Running score, Greenspan two, market forces two.


On the money front, we give the Fed one big win, one huge loss, and one substantial loss.  The narrowest money supply measure, M1, grew by only 1.6% over the last six months.  If you have read any history at all on central banks and fiat currencies, you know that is a grand and rare achievement for a central banker to maintain that much fiat discipline, so this is a big win for Greenspan.  On the other hand, the Fed dangerously allowed Money of Zero Maturity to utterly explode in the first half of the year, growing at a blistering 21% annual clip!  M3, the broadest money supply measure, did not go as nuclear as MZM, but still roared ahead by 12% on an annualized basis.


When viewed in light of the lethargic and wilting growth of the US economy, all we can say is “YIKES!” regarding these exploding money supplies.  When relatively more dollars chase after relatively fewer goods and services, inflation is the ultimate result.  Always.  Because of this gross fiat negligence, our running tally now gives Greenspan three and market forces four, an exciting game thus far!


With broader money supplies promiscuously multiplying like rabbits in the springtime, there is no doubt that we WILL witness goods and services inflation in the future.  Amazingly, all the new money shot into the veins of the economy by the Greenspan Gambit has only increased the CPI at a 4.3% annual rate so far during the six rate cuts.  Although this inflation rate is low compared to a banana republic, it is still high for the world’s premier economy.  We chalk it up as a loss for Mr. Greenspan.  On the other hand, thanks to the hammering of energy prices and the slowing economy, producer prices were very stable, only witnessing a 0.3% gain in H1 2001.  The scorecard now gives Greenspan four and market forces five.  Central planning is behind by a hair.


A second huge loss occurred in the Fed’s dire impact on the one year gold carry trade profit spread.  With short-term Treasury rates plummeting and gold lease rates rising quite dramatically during the frenzied easing extravaganza, the amount of interest rate spread profits achievable in the gold carry hemorrhaged by an ugly 61%!  Next time all the world central bankers have one of their closed-door hootenannies and do whatever it is elite bankers do when they get together, the central banks that still want to lease their gold onto the market are sure to have a word or two for Greenspan about annihilating the incentives for the gold carry.  Since gold is the ultimate nemesis of fiat-currency loving central bankers everywhere, we think the destruction of the gold carry is a BIG loss for the Fed.


In a fiat paper world, one thing that Wall Street and the bankers do NOT want is commodities to rise in price.  Rising general commodity price levels can signal currency inflation and tell the entire world that a fiat currency is weakening because the central bankers are printing too much of it.  Of course, individual commodity moves are often supply and demand stories, but when the whole commodity universe moves together it is often making a statement about fiat currency values.  The two most important commodities in the world are gold and oil.


Gold is the ultimate standard of value and has held that undisputed crown for six millennia of human history.  Central banks come and go, countries rise and fall, empires glory and fade, currencies blink into existence and deteriorate into oblivion, yet gold always maintains its value as the only form of financial wealth that is not based on someone else’s promise to pay.  Since gold is always the mighty market gladiator that gives the thumbs-up or thumbs-down signal that tells the world if a particular fiat currency will live or die, central bankers absolutely LOATHE it.  For this reason, we think the Fed will view the unchanged gold price in the last six months as a major victory.


Oil is the lifeblood of our modern ultra-complex global economy.  If we lost the ability to burn the long extinct dinosaurs and swamps to fuel our mobile lifestyles and world trade, civilization as we know it would no doubt grind to a halt and crash.  Although we need vast amounts of oil, free market oil prices infuriate central planners when they are deemed too high.  High energy prices take dollars away from consumers that Wall Street wants spent on technology, or stocks, or ANYTHING but oil.  Since the financial world and the governments that do not produce oil just viscerally abhor high oil prices, we think the Fed has another major win on its hands as the oil price fell over the first half of 2001.


The scorecard now gives Greenspan and his crew six wins, and market forces six wins.  Even game, once again.  Oh the excitement!


And that brings us to the stock market.  Ahhh, the stock market!


Does everyone remember the fanatical bullish euphoria in early February after two rate cuts and 100 basis points?  Wall Street analysts were literally falling all over themselves in their zeal to tell all of us dumb, uneducated bumpkins living outside of Wall Street how interest rate cuts are ALWAYS bullish for the stock markets.  “Don’t fight the Fed,” they droned on, “NOW is the time to buy.”  “The bull is back.”  “Get fully invested or you will miss the ride,” they solemnly proclaimed.


Interest rate cuts are ALWAYS bullish for stocks?  Really?  I wonder if our Japanese friends know this.  Perhaps some one should bestow this pearl of market wisdom on them to help them out.  They burned interest rates down to zero and it didn’t help their post-bubble markets one bit.  It didn’t work back in the 1930s in the States either.


Of course, the perma-bulls just laugh at the idea that this time in the States could see market behavior like the 1930s.  They quickly expound the five most dangerous words for any investor, “This time it IS different.”  The same professional Wall Street crowd who lacked the courage and foresight to call a spade a spade last spring and warn of the bubble now virtually all admit the NASDAQ was indeed a bubble.  A whole lot of help THAT stunning revelation does for investors now after their capital has been obliterated!  Even worse, the ever-bullish professionals claim that even though we DID witness a bubble in the States, all is well now.  Happy days are here again.


The great market debate of 2001 has centered around a single simple question…  Do bubbles have consequences or do they not?  All of economic history tells us that once a giant bubble grows large like a terminal malignant financial cancer in a nation, ALL the speculative excesses have to be painfully unwound over years and years, ultimately taking markets to valuations far, far lower than normal. 


Yet, Wall Street would have its clients believe that, yes, even though there was a bubble last year, that all the consequences were neatly condensed and packaged into one short year of NASDAQ carnage.  As students of history, we have to laugh out loud at that bit of Wall Street “wisdom”.  The same folks who told us NASDAQ was going to 6000 the day it broke through 5000 now tell us that all is well, the bubble is dead and gone, and there will be no consequences for the massive speculative excesses that still exist in the US markets and economy.  They claim that for the first time in history the causal boom-bust effect chain has been miraculously broken.


Whether bull or bear, no matter where opinions on the future of this US bubble stand, there is no arguing with the cold hard market stats. 


SIX rapid-fire rate cuts!  TWO inter-meeting EMERGENCY deep 50 basis point rate cuts!  275 basis points of slashing in merely 180 days!  And how did the stock markets perform through all this hyper-stimulation?  The Dow hung in there at a 3.3% loss, but no big rally arose which the bulls had prophesied.  The more speculative S&P 500, the 500 biggest and best companies in America, managed an ugly 8.4% loss on the positive news of the rate cuts.  The highly speculative no-man’s-land of the NASDAQ casino shed a full 16% of investor capital in the six months Greenspan and crew have been goosing the markets.  Don’t fight the Fed?


Do bubbles have consequences?  Or don’t they?  The equity bulls sure have a lot of explaining to do regarding why Greenspan’s unprecedented rate cuts did not appear to do a thing for the overvalued US equity markets.  The current popular excuse is the standard six-to-nine month lag theory of interest rate impact, but we remain highly skeptical.  We will all have to patiently wait and see how the markets actually close 2001 to really determine if the Greenspan Gambit has resuscitated them back from near death or simply delayed their trip into the grave.


Score, Greenspan six, market forces nine.  Take that, Central Planning Committees!


Finally, arguably the most important US financial lynchpin of all, the US dollar.  The whole body of economic history suggests that interest rate cuts tend to REDUCE the value of a currency.  As a central bank slashes interest rates, returns are reduced for foreigners holding its currency and classical economic theory indicates the currency should be sold off, cutting its value.  Interest rate cuts in the economy of one currency make it less competitive with other world currencies. 


For not entirely clear reasons, the US dollar has actually defied logic and RALLIED a huge 8.3% through the most aggressive six month Fed easing cycle in history.  This is a mega-win for Greenspan and his crew in that they didn’t crash the vastly overvalued US dollar with their rate-cutting dog-and-pony show.  We are quite certain that even they are highly surprised that the dollar is much higher now than it was 275 basis points ago.  Will wonders never cease in this “New Era”?


Part of the reason for the resilient dollar strength may be because the US equity markets are the only real speculative game in town, seducing in trillions of dollars of “hot money” from all over the globe like bugs to a headlamp.  Another reason may be because the US dollar is the lesser of the great fiat evils. 


The Japanese yen is doing horribly following the Japanese bubble burst (ask our Japanese friends if speculative bubbles have consequences).  The Euro is bordering on stillborn, limping along hobbled by a bunch of socialist stooges in Brussels who are on such a demented power trip that they think that trivial things like chocolate recipes and the number of holes in Swiss cheese must be strictly regulated in Euroland.  Not to mention their Draconian big-brother cash reporting laws that the Euro bureaucrats are imposing to track every penny of old currencies that hard-working Europeans convert to Euros.  It is not surprising the Euro is a basketcase.


We Americans have to count our blessings that Washington is still kind of sort of accountable to us taxpayers unlike the faceless unelected, unaccountable European socialist megalomaniacs trying to strut their stuff and shove their power down the throats of the smallest corners of the once great European nations that have foolishly abdicated their precious national sovereignty.  Compared to the Euro, the rapidly inflating US dollar is indeed the Rock of Gibraltar of world currencies.


Of course, a strong dollar is bad for the US economy, so it is a double-edged sword for the Fed.  The grossly overvalued dollar makes life incredibly miserable for US companies that export goods around the world or compete domestically with imported goods, as the National Association of Manufacturers recently tried to desperately convince Secretary of the Treasury Paul O’Neill to no avail.


As our brief halftime diversion draws to a close, we are currently scoring the game at Greenspan and the Fed seven, market forces nine.


The second half of 2001 promises to be very exciting as these titanic forces continue their epic melee.  We are eagerly anticipating plunging into the second half to see what mysteries and wonders doth await on the other side.


Will regulatory fiat decision-by-committee short-circuit the boom bust cycle as the New Era faithful hope?  Or will fundamentals and history once again exert their mighty power and slam equity valuations back down to reality?


Adam Hamilton, CPA     June 29, 2001     Subscribe