Mr. Greenspan Faces a Momentous Dilemma

February 8, 1999

Bullish euphoria was severely dampened this week as the yield on the 30-year US government bond surged to 5.35% from last Friday's 5.09%. Sentiment has quickly shifted to the recognition that interest rates are now acutely very vulnerable to an overheated economy. For the week, the Dow declined about one-half percent and the S&P500 was hit for 3%. The bulls shifted to economically sensitive stocks this week with the Morgan Stanley Cyclical index rising 3% and the Transports up more than 1%. The Morgan Stanley Consumer index suffered a 1% decline. Market leadership, however, took a pounding as both the technology and financial stocks suffered significant declines as interest rates rose. Higher rates certainly will hurt the highly leveraged financial sector as well as making absurd valuations throughout the tech sector look even more outrageous. The S&P Bank index declined 5% and the Bloomberg Wall Street index dropped 3%. The high flying tech stocks, however, suffered the biggest losses. For the week, the NASDAQ 100 declined 6%, the Morgan Stanley High Tech index 7%, and semiconductor stocks 8%. The Internet stocks were hit for a 4% loss. The Prudent Bear Fund gained 4.4%, while the NASDAQ Composite average lost 5.3%.

Last Thursday, as expected, the Federal Reserve decided to leave interest rates unchanged. This decision extends the Fed's aggressively accommodative posture that has been pursued since its dramatic action this past autumn, cutting interest rates three times in a period of about six weeks. Clearly, the Fed's decision at the time had little to do with the economy but, instead, was a desperate response to the fear of a potential financial market crisis related to the collapse of Long Term Capital Management and the tenuous state of other reckless speculators. Massive leverage had come to permeate our financial system, apparently somehow unbeknownst to the Federal Reserve, as Wall Street and the hedge fund community had borrowed heavily from Japan and from US money markets to finance hundreds of billions in higher yielding securities. This fiasco almost brought our financial system to the brink - and is likely the greatest financial speculation ever, with as yet untold consequences.

But with this "house of cards" ready to collapse, Mr. Greenspan quickly stepped in to ensure that even more credit would be created to keep the game going. And, indeed, the market responded quickly, having grown accustomed to such Fed patronage many times before. Looking back, Mr. Greenspan came to the rescue back in 1987 after the stock market crash; again in the early 90's with the banking and S&L crisis; and in 1995 with the Mexican crisis and Orange County derivative fiasco and bankruptcy. Little wonder Mr. Greenspan is Wall Street's favorite central banker ever and also there is little question historians will look back with great consternation at the "moral hazard" that he created in the marketplace; each of his bailouts leading to more egregious booms and more problematic busts.

Back in the 1960's, Mr. Greenspan spoke and wrote extensively about the Great Depression and the factors that led to this most catastrophic financial and economic collapse. He adamantly pinned responsibility on a misguided Federal Reserve that had accommodated excessive credit growth that fueled a dangerous stock market speculative bubble and maladjusted economy. Mr. Greenspan also used an interesting and quite fitting analogy, stating that the Federal Reserve in the 1920s repeatedly "put a coin in the fuse box." When the Fed was confronted with intermittent financial crises, especially in the late 1920s as much of the world lurched towards financial and economic collapse, the Fed would move to short-circuit the markets, injecting liquidity and accommodating unsound credit and speculative excesses, working diligently to forestall financial crisis and recession. Yes, the Fed did succeed for some time, at least until the "coined" fuse box eventually succumbed and the "house" – the entire financial system – virtually incinerated. Back in the 1960s, the astute economist Greenspan understood clearly the catastrophe of central banks interfering with markets and how it only stoked the unsound boom and led to a much greater collapse.

Well, today Mr. Greenspan faces a momentous dilemma. With each of his bailouts leading to even bigger problems, he appears to be getting near the end of his rope. His latest move to support the markets last quarter forced him to throw gas on an already overheated economy and financial system, an economy already in the midst of the longest peacetime expansion on record, and a stock market that had doubled in just over the past two years. And with Mr. Greenspan's blessing, M3 money supply grew $200 billion for the quarter, 40% more than the growth during the 4th quarter of 1997. Fannie Mae and Freddie Mac lowered mortgage rates, inciting a massive refinancing boom and Fannie and Freddie ballooned their balance sheets by $88 billion during the quarter, adding incredible liquidity throughout the financial system. The stock market exploded and the economy turned red-hot. The stock market rise created more than $2 trillion of perceived wealth and consumers and businesses alike rejoiced in the all-powerful Federal Reserve and proceeded to borrow-and-spend like never before. Along the way, we also had more than five million individuals open on-line stock trading accounts and the transformation of Wall Street into the greatest casino ever was complete. In short, the party got way out of hand with the Fed spiking the punch bowl with some pretty strong stuff. This "liquid courage" engendered a new, perilous strain of "irrational exuberance."

During the fourth quarter, the economy grew at a 5.6% rate, with record consumer spending, while fixed business investment surged almost 17%. 1998 also easily surpassed the previous record for new home sales, fully 10% greater than a strong 1997. November and December were actually the two strongest months ever for new home sales, with sales booming 20% in the West in December. Housing starts in December were the strongest in 12 years, and total construction spending surged 10% from the previous year. December auto sales were the strongest since 1986, and it was the biggest Christmas selling season in years. The savings rate went into negative territory for the first time since the Great Depression and our current account deficit exploded to more than $20 billion per month.

And to begin the New Year, the stock market boom continued with the NASDAQ 100 rising almost 20%. And with unemployment at a 28-year low and consumer confidence recovering back to near records, consumption exploded. January retail sales increased more than 8% with same store sales growth of 10% at Wal-Mart, 11% at the Limited, 15% for the Gap, and 10% at Dayton Hudson. Auto sales were even stronger with industry sales rising more than 9%. Daimler-Chrysler sales surged 19%, Toyota 27%, Ford's 9% sales gains more than doubled forecasts as sales of its pickups, sports utility, and its minivan line exploded for a 22% gain. Sales of luxury vehicles were stellar with Honda's Acura unit posting a 29% gain, BMW 17%, Volvo 18%, and Porsche 77%. Toyota's Lexus division had its strongest month ever with a gain of 47%. Elsewhere in the economy, the National Association of Purchasing Manager's index of manufacturing activity rebounded to the strongest level since May, a separate report on non-manufacturing showed a similar surge in activity, construction spending reported its seventh straight monthly rise, factory orders came in almost double expectations, and initial jobless claims contracted sharply. Today's employment report showed job gains of 245,000, almost double expectations, with wages rising strongly and the overheated service sector creating 252,000 jobs in January.

In short, it is time to pronounce an end to the so-called "Goldilocks" economy and recognize that the Fed has made what certainly qualifies as one of the great blunders in the history of central banking. In a desperate attempt to maintain the US financial and economic bubble, the Fed has only fomented greater excesses in credit creation and speculation and certainly has only exacerbated an already perilous situation. US companies have taken on more debt, as have American families. More money has been recklessly thrown at the stock market in the greatest mania of all time, and more capital and credit have been directed to uneconomic businesses. As a nation, we have consumed way beyond our means, and our trade deficit has been allowed to explode, thus jeopardizing the long-term stability of our currency, financial markets and economic well being.

And importantly, for the near term health of the stock market, interest rates look to be headed higher which is particularly problematic for our highly leveraged financial system and acutely speculative and highly overvalued stock market. For years, the bulls have justified ever-higher stock market valuations by citing low and falling interest rates, claiming stocks as being safe until rates rise. Well today, a strong case can be made that the probability of lower rates is slim, and that a surprising move higher is much more likely. With earnings faltering, a global financial and economic crisis, and, now, higher domestic interest rates, it looks like an important inflection point has been crossed. The risk of a significant decline in stock prices is now higher than ever before.

A single ounce of gold (about 28 grams) can be stretched into a gold thread 5 miles (8 kilometers) long.

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