When did the Greenspan "Put" become the Greenspan "Call"?

By: Bob Hoye | Wed, Oct 3, 2007
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Generally, the Greenspan "Put" has been the notion that the Fed would flood the money markets to prevent an abysmal decline from excessive highs in the stock market. Therefore, on 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 FMOC.

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 in 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 to 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 and inspired by 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" of 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 cliché dating back to at least 1825. A period of uncharacteristic accommodation by the Bank of England 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 naiveté 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 Mr. 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. (Wilshire 5000 high was set in July.) 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 data base for history books yet to be published.

Beyond providing rather good timing there are some other features of the curve. Now, most agree that on 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 U. S. data base 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 U.S. 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 Clinton's economic advisor until taking the office of Treasury Secretary from January 1995 until July 1999. Andrew Mellon 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 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. Andrew 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 Mr. Mellon's reputation as an outstanding financial officer of the U. S. government.

As with 1929 and the 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".

What a posterity.



Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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