A Crisis in Confidence: The Fed Reacts
...there will most definitely be a prolonged period for opportunistic investors to take advantage of market dislocations and inefficiencies.
I pride myself on being open-minded and ready for most anything in the markets. Markets have a habit of doing the unexpected, particularly when the majority doesn't expect it. In Wall Street circles, this is referred to as the 'pain trade'.
The pain trade, simply stated, is the trade that frustrates and causes the most pain for the majority, usually at extremes. Over the past 10 years, we have witnessed the Federal Reserve become increasingly more active in the markets-sometimes in a covert way (many of us believe in the 'Plunge Protection Team' assembled by Alan Greenspan and friends to stabilize US markets in the days following October 1987). Since 1998, however, the game has changed, and changed in a big way. The Fed is no longer covert in its actions. Rather, it is increasingly in the public eye on a day to day basis as the economy has switched more and more to an 'asset based economy,' as opposed to an economy that is not dependent on asset prices rising forever.
In this missive, I will highlight charts and news headlines by Fed officials that demonstrate, why I feel that the Fed is now desperate. It is desperate and it has told us so in many words. Why would Central Bankers worldwide intervene in the securities markets in such an obvious manner? I believe they are re-initiating the 'moral hazard card' that was put into play by none other than the 'Maestro' himself, Alan Greenspan, during his tenure as Fed Chairman. Instead of the 'Greenspan put' we now are experiencing, in my opinion, a global effort by central bankers to keep asset markets afloat. This is fact. And they are facts that unless we know of them, we have no chance to perform well in the months and years ahead. Speaking for myself and my partners, we are indeed ready for what the Central Bankers are attempting to do, and are looking forward to the challenge. For more, read on.
The Fed Panics
I have been talking for a couple of years about the Fed's involvement in the market, incredible growth in money stock (M3), and the dangers of sub-prime going from contained to contagion. Clearly, the Fed sees what I see as it made an about-face in a matter of 36 hours from being concerned about inflation to panicking into lowering the discount rate (the rate they charge to banks as a 'lender of last resort') and flooding the system with cash. See the Fed comments from its most recent FOMC meeting and also headlines captured from Bloomberg. I think that these pictures will speak volumes and show the Fed's desperate mentality.
Fed Minutes from June 27, 2007 (left), and Fed Minutes from August 7, 2007 (right)
Click here to enlarge.
Comments from St. Louis Fed Governor William Poole on Wednesday August 15th 2007
- Poole says not 'desirable' for Fed to act before rate meeting.
- Poole says no impact yet on 'real economy' from market 'upset'.
Early on August 17th, 2007: The Fed Makes an About-Face
- Fed says FOMC prepared to 'act as needed' to help economy.
And Then on August 21st, 2007 from Fed Governor Jeffery Lacker
- Lacker says Fed policy must be guided by economic outlook.
- Lacker says market volatility need not require Fed rate cut.
And then by Senator Dodd Talking About the Markets on August 17th 2007
- Dodd urges additional steps to help borrowers keep their homes.
- Dodd says regulators need to ensure lending abuses don't recur.
- Dodd urges creation of additional liquidity for US markets.
- Dodd says he remains concerned about subprime mortgage market.
The Fed Admits Buying Commercial Paper at the Discount Window-August 24th 2007
Click here to enlarge.
Here in Florida, people like to say that if you don't like the weather, stick around for a few minutes. The same can be said for one of my favorite places on Earth - Northwest Montana. I have no issue having weather changing on a moment's notice, but the Fed? This is something that I am not shocked by, but on the same token, am not happy about in the least. In my opinion, the US needs a stable governing body to guide a prudent monetary policy to let markets function normally and without intervention. But ever since the Long Term Capital Management bailout in 1998 (also accompanied by an intra-meeting rate cut), I have come to the conclusion that the Fed would eventually become desperate enough to come out of the closet and no longer have a clandestine view towards intervention, but rather tell us it are intervening. And indeed it is.
The danger of course, is that while the intervention may work for a while, it will not work forever as 'the laws of large numbers will take over as debt overwhelmed no matter what the Fed tries to do. This saddens me for those unprepared but like they say, 'to be forewarned is to be forearmed'. So the rules of the game are laid out in front of us and we must play by those rules. To ignore them, if you are bullish, bearish or neutral is to be ignorant of your surroundings. I am most definitely aware of the new rules and will play by those rules accordingly.
The Current State of Debt Markets and the Effects of Intervention
It feels like I have been writing about the debt bubble present in the U.S. forever, but I thought an update was appropriate. See the chart below highlighting continued outrageous money supply growth, courtesy of Ned Davis Research and www.nowandfutures.com.
M3b: The Broadest Measure of the Money Supply
Click here to enlarge.
What has the Market Impact been post Fed-Intervention?
This all started when libor drifted away from the European Central Bank's target rate a couple of weeks ago and there was an injection of liquidity to markets worldwide, from the ECB to Australia to US markets. Why is this important information? Consider this. If someone would have told you and me that there would be global Central Bank intervention into US markets when most major stock indices were within 5 percent of their all-time highs, would you have believed it? I, for one, would have thought it preposterous.
At any rate, they have indeed stepped into the fray because it is not the equity markets that are unraveling; it is the credit markets that are unraveling. And credit markets are the fabric of an asset-based economy and the best I can tell, credit markets (outside of GNMA/FNMA) are not operating 'normally'. I know this because I have tried to sell, on behalf of a client, $20,000,000 of high grade short-term corporate bonds and it took me four days to sell them at the level I wanted. In days passed, it would have taken four minutes. Traders at most firms are being told to 'stay small' - Wall Street lingo for staying 'lean and mean'. This explains why the Fed has taken the unusual and drastic measures of accepting everything from Commercial Paper to Junk Bonds at the Discount Window as collateral. Let's take a quick look at just how unnerved the market has become. The chart following shows the recent yield of Treasury Bills maturing September 20th 2007. Pictures do indeed tell 1000 words.
Bond Equivalent Yield of Treasury Bills Maturing September 20th 2007
Click here to enlarge.
This leads me to a most important question. Is the Wall Street issue becoming a Main Street issue? What I am saying is that Wall Street is known for exaggerating the moves of the real economy (some actually claim that 'the stock market has predicted 20 of the last 10 recessions'). But have the real economy and the asset based economy, courtesy of Greenspan and Bernanke, become intertwined forevermore?
Personally, I am a proponent of something I was taught in college called 'Social Darwinism'. Darwin believed in 'survival of the fittest', which is by no means fun if you are not among the fittest. Like a good friend of mine today said 'it is no fun to watch a forest fire burn but it burns for a reason, so the forest can thrive long-term'. It was an interesting analogy and one that I immediately agreed with. Businesses need to fail so that many others can learn from their mistakes, which in the old days was referred to as the 'business cycle. Without a true cycle, the longer we allow an artificially bloated financial system to prosper, the larger the eventual correction. I imagine that some people I know might fail, but we need a real cycle if we desire a long-term economic cycle. In case you don't believe that Wall Street has met Main Street, see the images below, courtesy of www.ml-implode.com and www.hf-implode.com.
Home Page of www.ml-imlode.com The Mortgage Lender 'Implode-O-Meter'
Home Page of www.hf-implode.com The Hedge Fund 'Implode-O-Meter'
In conclusion, we indeed face interesting times. The credit cycle that has been extended longer than usual is finally coming home to roost. This is not unusual in the least as markets and cycles tend to go through boom and bust scenarios. The Fed, ECB and other Central Banks seem reluctant to let the cycle have its normal downswing this time around, hoping for some sort of alchemy. Whether it works is anyone's guess, but I stand by my cautious view towards credit and will be opportunistic as usual with the main goal or capital preservation in clear view. In my opinion, there will most definitely be a prolonged period for opportunistic investors to take advantage of market dislocations and inefficiencies. We indeed hope that we will be the investors that seize the opportunities in the days ahead.
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