WHAT'S MOVING THE MARKETS?November 27, 2005 - In the brief period since President Bush announced his choice for the new Federal Reserve Board Chairman, a number of major financial markets have been dramatically affected. The purpose of this essay is to explore whether the hand of Alan Greenspan or his likely replacement, Ben Bernanke, were behind them. Or, are the forces driving these normally divergent markets in the same direction simply the result of the investment community's expression of support and agreement at the change of guard at the Fed, or is some other force at work?
It has been four weeks since October 24. This was when Ben Bernanke was named the president's choice to ascend to what is arguably the most powerful position in our nation if not the world. No sooner did President Bush recommended his replacement for the departing Alan Greenspan, than four of the most significant markets began to react. The boldest and most persistently strong one has been the U.S. stock market. At the time, the Dow Jones Industrials were in the midst of a decline. It began about five weeks earlier from about 10,700, and had taken the Dow to its pre-announcement level of about 10,300. On the day of his recommendation, the Industrials appeared to greet Bernanke and strongly rose 170 points. The Dow then proceeded to fall for the next few days but has since climbed nearly vertically to Friday's 10,931 closing price. This places its upward assault within striking distance of an all-time high.
The US Dollar Index was trading at about 89.50. After a brief three day set-back it soared in lock-step fashion with the Dow. Within three weeks it touched 92.50. When it bumped into strong resistance at the 92.50 level it paused temporarily, but is now working to overcome it.
Bonds were in a sustained decline since late August. After President Bush's announcement the bond market severely reacted, and in three days lost 225 basis points. It then proceeded lower for several more days, sharply reversed course, and then joined common stocks and the dollar in their upward climb.
The gold market is the final market of this quartet. After Bernanke's nomination it rose strongly for a few days and then fell sharply. After posting a 458 nadir it then reversed direction and exploded in price. It now rests on the doorstep of a major milestone, the 500 level.
Since Ben Bernanke's nomination, the world has experienced a rarely witnessed event. What is so amazing is the fact that these major markets are driven by varying and opposing forces, yet they are together trending higher. I cannot state that it is unprecedented. However, after each had sufficiently digested the news, these four crucial markets moved higher in tandem. By acting in this fashion they are defying both historical market relationships, conventional wisdom, and common sense.
The U.S. dollar and gold tend to move in opposition to one another. This is due to gold's historic negative correlation with the dollar. U.S. common stocks and bonds were in defined downtrends. Yet, Bernanke's nomination seemed to virtually simultaneously put wind behind the sails of all of these primary American markets. This may only be a fleeting phenomenon, but if not, how and why are we witnessing this seemingly surreal event?
One belief is that Alan Greenspan orchestrated the market advances. Given his long tenure as Fed chairman I am certain that he would like to leave his watch with the markets calm. Stronger equity, bond and dollar markets that carried through his departure, would certainly make his exit more fitting for what the American Public would expect of the Maestro. It would also please Greenspan as it would give future historians few negatives to discuss when describing his legacy.
In a similar fashion, it would be to Dr. Bernanke's benefit if the markets appeared to rejoice in his ascendency to the chairmanship of the Federal Reserve System. If this transpired it would certainly comfort the market's participants and onlookers on the eve of Greenspan's stepping down.
There are a plethora of potential crisis generating conditions that are lurking in the wings of both our nation and the world's financial and economic systems. An easy transition from a Greenspan to a Bernanke Fed would act to mitigate and assuage many lingering fears.
After all, the derivative monsters that envelop not only the currency and equity markets, but also the bond, credit and various other markets, has the potential to bring down the entire financial system if an accident emerges. This nearly occurred in1998, with Long Term Capital Management, and possibly with the recent apparent insolvency of Refco. The break-up of the latter company appears to be under control. However, potential derivative or undisclosed losses may yet surface and create havoc in the markets. Little information has been reported by the regulators or the media to reasonably explain the speed with which the company is being dismantled. Further, no one in the company seems to be objecting.
Other potential dangers surround the fate of common stocks and real estate. Despite their recent impressive strength, equities may shortly experience a continuation of their secular Bear Market decline. Numerous indicators are signaling warnings of their impending weakness. Additionally, the housing market may be taking a breather, but the future of its Bull Market appears tenuous at present. If either of these markets soften substantially, it has the potential to snowball and not only damage the underpinnings of the other, but also the general economy. Additionally, how long will the rest of the world continue to desire the fiat dollars that our Federal Reserve System creates at will? Given our unsustainable balance of trade, payments, and budget deficits, the United States NEEDS the rest of the world to continue to accept our dollars and purchase our Treasuries. If they eventually rebel, it will devastate our economy and unleash a likely inflationary firestorm when their dollars return to our shores.
The possibility of these and other potential disasters will soon consume the waking hours of Dr. Ben S. Bernanke. If the markets do not appear to accept him when he takes control of the Fed, he may be forced to endure a test of fire.
This would not be unique. Both former Fed chairmen Paul Volker and Alan Greenspan were greeted by major economic convulsions shortly after they each took their oath to office. Volker watched short term interest rates soar to 20% and a recession unfold, and Greenspan presided over the devastating stock market crash of October, 1987.
The classical methods that Alan Greenspan can utilize to foster rising bond, stock and dollar markets are not foreign to long-term observers of the Fed in action. The problem is that all of these markets can't be simultaneously stimulated with these means. The Federal Reserve routinely purchases U.S. Treasuries in the open market. This acts to strengthen the bond market, reduces interest rates, and allows the Fed to immediately inject a substantial number of dollars into the banking system. Or, Greenspan can lower the Federal Reserve member banks' reserve requirements. This action gives the banks the capacity to expand their lending ability, which through a multiplier effect also increases the money supply. The Fed can also manipulate the Federal Funds and Discount rates lower, thereby suppressing interest rates. All of these actions increase our domestic liquidity and have been primary drivers of higher stock prices.
As for the dollar, rising interest rates tend to buoy its strength while falling rates weaken it. Also, Federal Reserve open market sales of Treasuries withdraw dollars from the monetary system thus increasing dollar desirability on the world's markets. If fewer dollars exist, by supply and demand, the remaining ones will ultimately experience an increase in their purchasing power. However, these standard market influencing Fed actions all take time to work their way through the system. Further, as you can see they conflict with one another in the varying effects that they have upon these markets. They could not simultaneously, positively influence the bond, stock and U.S. dollar markets, let alone gold prices.
While Dr. Bernanke has not yet been installed as Fed chairman he may be operating behind the scenes with Greenspan's guidance. Bernanke essentially came from out of nowhere in 2002, and uttered numerous highly controversial statements. Then, earlier this year found himself appointed to the lead post of President Bush's personal economic advisors. In this position he was likely personally groomed for his future Federal Reserve position.
I believe that it is reasonable to assume that Alan Greenspan's replacement by Ben Bernanke was made long before the official announcement. It certainly appears that he caught President Bush's attention with his 2002 statements if not earlier.
Unfortunately, given the fact that he will likely be our next Fed chairman I think it was a mistake to broadcast his intentions in advance. This will limit their effectiveness if and when they are implemented.
If he used the conventional Fed methods to effect monetary policy as I described above, Dr. Bernanke would have no greater ability than Alan Greenspan to move these markets higher in concert. For this reason, if classical Federal Reserve techniques were solely utilized, I believe that one can eliminate Greenspan and Bernanke as the influencing forces behind the concurrent rises in these markets.
Where does this leave us in determining the causative forces behind the simultaneous uptrends in all of these markets? It could be a coincidence. Yet, a few days would be one thing, but for three weeks already is a different story.
IF IT'S NOT GREENSPAN, BERNANKE
OR A COINCIDENCE,
Upon further evaluation of this puzzle a though occurred to me. It took me back to Dr. Bernanke's November, 2002 statements when he was a relative unknown. He stated that the Fed had the ability to create dollars at will by various unconventional means. In this regard I truly believe him.
I personally do not believe that the markets are sufficiently convinced that Dr. Benjamin S. Bernanke will be an able replacement for Alan Greenspan. He very well may be, but he is as yet unproven. From my long experience observing and studying the markets, I have found that they typically react negatively to any form of uncertainty! And, to my mind, any replacement of the revered Alan Greenspan, would be looked upon with a questioning eye by all national leaders and anyone concerned about the markets.
If I am correct, the uncertainty generated by any untested, new Fed chairman would at best cause the markets to pause if not decline. I believe that the bond market's initial sell-off was and should be the typical response. Then why would stocks, bonds, the dollar and gold instead simultaneously rise? To my mind, the only logical explanation would be a concerted market intervention effort.
I for one believe in free, uncontrolled markets. I also believe that our government recognizes the unwelcomed fashion in which the markets greeted both Paul Volker and Alan Greenspan upon their appointments as Fed chairmen. For this reason it seems likely that they would do their best to smooth the path for the January, 2006, Fed chairman transition. This truly would be to the benefit of all Americans. While I do not agree with this action, I do understand the reasoning behind it if this is indeed what is occurring. And, I am certain of their ability to execute these effects, at least in the short term.
But, why would they want a strong gold price? The answer is that they wouldn't! That to me is the most telling market performance produced by Dr. Bernanke's nomination!
I believe that gold's powerful, positive reaction indicates that a number of world governments and important market players also believe Bernanke. They realize that when he implements his stated actions the result will be an extended, substantial decline in the dollar's value. Further, I am convinced that the Fed's recent decision to withhold future changes in the broad measure of the U.S. money supply, M3, has confirmed that belief in the minds of many government and other influential leaders. Much has occurred in the four weeks since Ben Bernanke's nomination!
On November 10, the Fed announced that M3 is costly to produce and is no longer significant in determining our nation's monetary policy. They gave these as the reasons for its discontinuance effective on March 23, 2006. Additionally, they will simultaneously cease to publish future changes in Eurodollar and repurchase agreement balances.
I suspect that this statement was internationally viewed as a method for our nation to cloak a likely massive future explosion of U.S. dollar credits. Further, I believe that Dr. Bernanke's nomination and this announcement that shortly followed it, were the primary influences behind the recent strength of gold that quickly took it to a new Bull Market high. If my reasoning is sound, the stage is now set for an increasing number of important national and international dollar holders to begin moving into gold. As time passes, this will benefit not only gold and gold shares, but numerous commodities and other tangible items. This will be the result of a flight from the dollar into these investments!
I hope that it doesn't come to pass. However, if Dr. Bernanke makes good on his word, he will likely go down in history as the Fed chairman who was responsible for creating the greatest flood of dollars, and the most damage to its domestic and international purchasing power in history. In this event, gold and gold related items will be the savior of the common man.
The above was excerpted from the December 2005 issue of Financial Insights © November 27, 2005.
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