When the 'Greenspan put' became a
'call' By Bob Hoye
Generally, the "Greenspan put" has been
the notion that the US Federal Reserve would flood
the money markets to prevent an abysmal decline
from excessive highs in the stock market.
Therefore, in the long term, there was no need to
be concerned about overweighting the stock market
- ever.
Perhaps convictions about this
aspect of modern portfolio theory were slightly
doubted during the travails that culminated in the
liquidity panic of October 2002. It is worth
noting that a few
hundred years of recurring
bull and bear markets suggests that central
bankers are rent-seekers mainly along for the
ride. And the idea that policy makers are timing
such cyclical events is expedient for those who
need the comfort of the ancient notion of Plato's
philosopher king, or at least in a secular
priesthood, called the Federal Open Market
Committee.
Despite evidence to the
contrary, the establishment still maintains the
artifice of a random walk economy, so that
inspired manipulations can be written on a clean
slate. The history of financial markets is an
endless thread of business prosperity and
subsequent recessions, bull and bear markets, as
well as great financial manias and their attendant
credit expansions and consequent contractions. The
thread runs through the past back to the
development of modern financial markets in the
last half of the 1600s.
This includes
periods of central bank accountability and
sobriety and this generation's remarkably reckless
experiment in artificial currencies and interest
rates, not to overlook artificial pricing and
ratings of artificial securities. With little
change in its resolute nature, financial history
will likely continue its record of euphoria and
dismay.
In the mid-1960s, inspired by
American neo-classical economist Paul Samuelson,
the economic establishment was absolutely
convinced that they had eliminated the business
cycle. But as the saying went, "they had a bear
market anyway". Other nonsense at the time
included "Operation Twist", whereby the Fed and
Treasury would buy enough bonds to drive interest
rates from 6% back to the "normal" 3%. That
operation was integral to long rates soaring to
15%, which was the highest ever reached in the
world's senior currency.
At the start of
the Greenspan era, the Fed enhanced its reputation
by "ending" the 1987 crash, which apparently
successful operation is a cliche dating to at
least 1825. At that time, a period of
uncharacteristic accommodation by the Bank of
England (BoE) when a financial bubble was due made
for a huge boom. The climax of speculation was
followed late in the year (1825) by a severe
liquidity crisis that ran until it naturally
exhausted itself. Afterwards, senior officers at
the BoE congratulated themselves in preventing the
panic from running forever.
The naivety
that massive liquidations will continue unless
ended by policy still remains in central banking
circles. Oddly enough, the concept that only
policy can prevent speculative collapses is as
ardently held.
Most have read Greenspan's
1966 condemnation of Fed policy during the
"Roaring Twenties", and it is a supreme irony that
during his watch the Fed and the Treasury outdid
the recklessness that was part of the 1929 bubble.
This recklessness has continued, and could
continue until enough asset classes become
unstable enough to end the extraordinary
speculation by market participants, as well as by
policy-makers.
The key to this fascinating
transition may be found in reviewing the action
common to the culmination of previous eras of
great asset inflations, or for that matter the end
of any business cycle - the change shows up in the
credit markets first . Within this, the yield
curve usually provides the critical signal as it
reverses from inverted to steepening. Then come
the problems in credit quality spreads.
Ironically, the senior central bank follows market
rates of interest.
Typically the final
phase of a booming stock market runs some 12 to 16
months against an inverted yield curve, and this
time around inversion started in February 2006.
This counted out to a potential top somewhere
around June of this year. Moreover, there is
little need to worry about rising interest rates
as they usually increase until the boom is
exhausted, and the time for concern is when
short-dated market rates of interest begin to
decline. Treasury bills increased to 5.18% at the
end of February and the subsequent decline was an
alert to possible change.
However, more
precision is offered by the reversal to
steepening, as short rates begin to decline
relative to long rates. One explanation is that it
is the intense demand for short-term funds by
speculators that drives short rates up, and this
seems to provide a sophisticated measure of
speculative abilities. Typically, as the curve
reverses to steepening it is the time when the
most blatant of speculations begin to fall apart.
The curve reversed by the end of May, and the rest
is making a database for history books yet to be
published. Beyond providing rather good timing,
there are some other features of the curve.
Now, most agree that in the near term the
Fed can push short rates for a while. Also, most
would agree that central bankers cannot
intentionally influence the long end, which
strongly suggests that changes in the curve are
independent of Fed interest rate manipulations.
This is confirmed by a review of the curve on a US
database back to the 1850s, and the rule is that
when the curve inverts and reverses to steepening,
a credit contraction and business recession
follows. It is worth noting that this has
prevailed during a variety of monetary systems.
When the US was between central banks and
on the Treasury System, a fiat currency was tried
until 1879 and then the gold standard prevailed,
but the curve actually drove the good times, or
the bad. Then under the Fed, the curve has done
its thing whether on a pseudo-gold standard until
1971 or a fiat currency since. There is a little
more to determining the transition from the
'Greenspan put' to the 'Greenspan call', and all
that that implies.
The greatest accolade
that can be laid on a financial policy-maker is to
be compared to Alexander Hamilton, who organized
the finances of the fledgling republic in the late
1700s. The most recent "greatest treasury
secretary since Alexander Hamilton" has been
Robert Rubin, who was president Bill Clinton's
economic advisor until taking the office of
treasury secretary from January 1995 until July
1999. Andrew Mellon, who served in the position
from 1921 until 1932 and during the late 1920s
also received the accolade.
As best as can
be determined, no other treasury secretary was so
capable as to receive the accolade, and the common
feature has been that the ones that did were in
office when a great financial bubble occurred.
This writer has not seen any mention of the
accolade being awarded to William A Richardson,
who was the secretary at the conclusion of the
mania in 1873, but the leading New York newspaper
editorialized that with his abilities and the fiat
currency there was nothing that could go wrong.
In 1884, leading economists described the
contraction as the "Great Depression" and although
it ended in 1895 it was still being analyzed under
the dreaded term until as late as 1939.
The observation is that it is the exciting
prosperity of a naturally occurring financial
mania that makes the reputation of the man who
just happens to be in office. Then there are those
who stayed too long. Mellon was an outstanding
banker and industrialist before taking over at
Treasury and was widely praised during the good
times. In not leaving the office until 1932, he
became the focus of the animosity typical of the
usual post-bubble recriminations. This turned to
outright hostility when in the face of socialist
New Dealers he advised that it would be best to
liquidate the "rottenness out of the system".
The end of the artificial prosperity of
the1920s financial mania was signaled as Treasury
bill rates turned down and the curve started its
reversal to steepening in the early summer of
1929. It also signaled the eventual demise of
Mellon's reputation as an outstanding financial
officer of the US government.
As with the
1929 and 1873 examples, the tide of speculation
turned with the yield curve in the early part of
the summer of this year. More specifically, the
curve completed the transition to steepening by
the end of May, and that could be considered the
time when the "Greenspan put" became the
"Greenspan call".
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