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Adam Hamilton

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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Rate Cut Scorecard Round Two

As we look back and marvel at a fascinating 2001, it becomes readily apparent what an action-packed year it truly proved to be.

Many incredible events transpired that directly impacted the financial markets, from the terror and devastation of the September 11 attacks to the hope and exhilaration of the enormous stealth rally in gold stocks in 2001. From the spectacular bankruptcies of Enron and Argentina to the magnificent fourth quarter rally in US equities, 2001 proved to be an exceedingly interesting and busy year on many fronts.

Yet, when future students of markets and economics study 2001, attempting to both understand the year and learn timeless lessons from the events we just lived through, one financial development's importance towers above all other contenders. In the first true year of the new millennium the United States Federal Reserve, for the first time in its entire 88-year history, slashed short-term interest rates an amazing 11 times in 11 months. Not even when mired in the abyssal depths of despair of the Great Depression did the Fed chart a similar extreme course!

The rate cuts are so hyper-important not simply because they set a record, but because they have such vast and far-reaching implications across so many major markets. Like some leviathan octopus straddling the entire US economy and to some extent the global economy, the Federal Reserve's Great Rate-Cutting Extravaganza of 2001 extended financial tentacles into virtually every conceivable economic nook and cranny in the United States.

The stock markets, the bond markets, the derivatives markets, the precious metals markets, and many other markets were, are, and will be impacted enormously by the current grand strategy of Alan Greenspan's Federal Reserve. The rate cuts were the common thread that knit together the patchwork quilt of otherwise disparate market action and events in 2001.

Way back on January 5, 2001, in the very first Zeal essay of the year, I kicked-off my 2001 commentaries discussing the surprise emergency 50 basis point inter-meeting interest rate cut of January 3 that rocked the US markets. In "The Greenspan Gambit", I couched the opening move of the current rate-slashing spree in terms of the great ancient strategy game of kings, chess.

Alan Greenspan's opening gambit was decisive, abrupt, unexpected, and had an amazing effect on the unsuspecting US equity markets. Halfway through trading on January 3, when the surprise news of the first Fed rate cut burned through the wires, the US markets rocketed. The NASDAQ roared up a breathtaking 14.2% in a few hours to 2617, its biggest single-day point and percentage gain in history. The broad S&P 500 was up an awesome 5% on the day. It was also the heaviest volume day ever witnessed on both the NASDAQ and the New York Stock Exchange to that moment in history, a truly momentous market event.

Of course, at the time the Wall Street crowd hailed the rate cuts as the Second Coming of the Great Bull. They said that the rate cuts may take "a few months" to reach their full potency in the economy, but claimed that the US equity markets "always" rallied when the Fed embarked upon an easy money policy campaign. At the time my research group collected a few dozen mainstream financial-press articles containing glowing bullish predictions rolling off the tongues of very prominent Wall Street analysts. We figured it would be fun and educational at some point in the future to look back and document the popular market sentiment rampant in early January 2001.

On January 5th, obviously one of the rare skeptics at the time, I wrote in the Greenspan Gambit essay, "The popular analogy claims trying to reinflate a busted credit bubble is like "pushing on a string". No matter how hard you push on one end of the string, it has zero effect on the opposite business end. Are you central bankers out there paying attention? If low interest rates, rapidly mushrooming cheap credit, and wild-west capital arrangements could stave off a post-bubble bust, the Nikkei would be trading over 100,000 today."

As the Greenspan Gambit spree of interest rate-slashing evolved throughout the year, I periodically penned other essays documenting the actual interest rate decisions, the markets' reactions, popular investor sentiment, and the perpetually growing body of evidence suggesting that Greenspan's last grand gamble was proving to be a devastating failure. One such essay, published at "half-time", the exact trading center of 2001, was called "Rate Cut Scorecard".

Six months ago as I still cynically pondered this great game I wrote, "Interest rate cuts are ALWAYS bullish for stocks? Really? I wonder if our Japanese friends know this. Perhaps some one should bestow this pearl of market wisdom on them to help them out. They burned interest rates down to zero and it didn't help their post-bubble markets one bit. It didn't work back in the 1930s in the States either. Of course, the perma-bulls just laugh at the idea that this time in the States could see market behavior like the 1930s. They quickly expound the five most dangerous words for any investor, "This time it IS different.""

In that ancient essay from six long months ago, we looked at 16 critical financial variables both before and after the Greenspan Gambit series of interest rate cuts. After six rapid-fire interest rate cuts in six months for a total of 275 basis points, we scored the great game at halftime at Alan Greenspan seven and the Free Markets nine.

We view the Greenspan Gambit in the terms of Alan Greenspan and the Federal Reserve versus the Free Markets for several reasons.

First, the free markets alone would do an infinitely better job of setting the price of money, interest rates. Having the Federal Open Market Committee, a small group of mere mortals acting on imperfect information, clumsily thrashing-about trying to miraculously divine the perfect interest rate is as ridiculous of concept as having the FOMC arbitrarily set by decree the price of every pair of shoes sold in the United States.

Second, the sinister concept of an elite committee that is unelected and unaccountable to the American people, meeting privately in a smoke-filled room where no raw transcripts of meetings are kept, and arbitrarily making financial decisions of unparalleled gravity for every saver, investor, and debtor in the United States has more in common with centrally-planned Soviet-style Communism than the mighty Invisible Hand of free-market capitalism.

Third, Alan Greenspan and his comrades are trying to subvert and corrupt normal free-market forces. Rather than being comfortable letting the free markets determine prices, as they should, the Federal Reserve has the curious anti-free market goals of padding inflated US equity market prices, maintaining the unnatural strength of the US dollar, and preventing the bond market from imposing discipline on the US economy.

With these three thoughts in mind, it is very obvious that Alan Greenspan and his private central bank are trying to aggressively bend market forces to politically-desirable outcomes, not letting the free markets sort things out as they naturally would if left unmolested. So, it is useful to think of this great game as Greenspan and the Fed versus the Free Markets. Only one side will emerge victorious.

Can Alan Greenspan and the Fed, for the first time in history, re-inflate a burst bubble and avoid the typical ensuing depression?

Now, with a whole year of observations under our belts, we have arrived at the end of Round Two of the Greenspan Gambit of 2001 interest rate-slashing. In the tradition of the earlier Rate Cut Scorecard essay, we will take a brief look at 16 critical market variables before and after the unprecedented 11 frantic interest rate cuts in 2001 that decapitated 475 basis points, or 73%, off short-term interest rates.

The raw data is presented in the table below. The "Before" column is data from late December 2000, immediately before the opening salvo surprise interest rate cut that kicked-off the Greenspan Gambit. The "After" column is the most-current available data for each variable as of market-close on December 26, 2001. The "Delta" column shows the percentage difference between each variable from before the rate cuts began until today. The "Win/Loss" column shows whether a given change in a variable is considered a victory or defeat FROM THE PERSPECTIVE OF ALAN GREENSPAN and the Federal Reserve.

Needless to say, those who wish to manipulate and molest the free markets are faring even worse now than they were six months ago in the terms of the variables outlined in this 2001 Round Two Rate Cut Scorecard.

2001 Fed Rate Cut Scorecard

Six months ago, the score was Greenspan seven and the Free Markets nine. Today, twelve months into the Greenspan Gambit, the score has widened to Greenspan six and the Free Markets ten. Yet the real carnage is not apparent on the scoreboard, but is only visible by digging deeper into the statistics outlined in the table above. We will begin with the first and most obvious category, interest rates.

Like a supertanker captain with only a single button at the helm to control his enormous vessel, Greenspan and the US Fed really only have one primary tool for attempting to influence market and economic events. Their big red button on the dashboard of the US economic supertanker is the ability to arbitrarily set by decree short-term interest rates. When they want to goose the economy they simply press the button to slash rates, and when they want to choke the economy they simply lift-off the button to raise rates, just like a crude throttle.

The results at this stage of the Greenspan Gambit on the interest rate front are not encouraging.

The graph below shows 19 months of important US interest rate data, encompassing the time from many months before the Greenspan Gambit to the present.

Greenspan vs. Free Markets

The yellow area shaded in the graph represents the actual Federal Funds Rate which the Federal Reserve first decrees directly with its fed funds target and then tries to maintain with tactical Open Market Operations. It plummeted from 6.5% to 1.75% in 2001, just as the doctor Greenspan ordered.

Very short-term interest rates, those on 90-day US Treasury bills, cooperated nicely with Greenspan, their yields plummeting by 69% from the levels at which they started 2001. Interestingly, as the black line in the graph above indicates, short Treasury yields led the Fed significantly all year. Some very astute market observers believe that the Fed was simply playing catch-up with the short bond market, which is an intriguing hypothesis. While the collapsed short-term interest rates are a victory for Alan Greenspan against the Free Market forces, the victory is definitely Pyrrhic.

While debtors and those who need to borrow money love low short-term rates, every economic transaction has two sides. The creditors, investors, and savers actually lending their hard-earned capital into the market for a return are being brutalized by the Greenspan Gambit. Before the rate-slashing extravaganza, everyone from sophisticated global bond investors to middle-class American retirees could earn a reasonable 5.7% on short-term Treasuries, enough to provide a fixed income. Now, thanks to Greenspan's vile and heartless declaration of total war on savers (see "Investment Capital Under Siege"), the short-term fixed income market has been carpet-bombed and left more barren than the desolate wastelands of Afghanistan.

Today, savers can only expect to earn around a paltry 1.7% on short-term lending, which is even well below the official rate of inflation! In effect, the US Fed has manipulated short-term interest rates so low that anyone saving money for future investment or consumption is actually losing wealth in real terms each year due to the scourge of inflation. It is a true tragedy. We strongly believe that Greenspan's War on Savers will have far-reaching and deadly unforeseen consequences before this whole Greenspan Gambit plays-out in the coming years. Trying to despicably terrorize prudent savers into dumping their hard-earned capital into overvalued equities in desperation is not the kind of action that makes an economy or nation great!

Even though short-term rates played Greenspan's game, long-term rates revolted.

Notice, however, that at the white dashed-line in the graph above long-term interest rates had begun trending significantly lower over a month before the initial surprise inter-meeting Fed rate cut in early January, marked by the white arrow. Rather than patiently letting free-market forces gradually push longer-term interest rates lower, the Fed's hasty and reckless action actually effectively created a floor under long-term rates as bond investors began to ponder the enormously inflationary consequences of the Fed's largesse.

While the equity investors salivated as they saw the easy money as a bailout of their silly speculations gone bad in overvalued tech stocks, bond investors saw easy money's true nature, a stealth inflation-tax on wealth, and longer-bonds were sold accordingly. Both the critical 10-year Treasury note and 30-year Treasury bond have higher yields now than before the Fed's latest desperate attempts to subvert free-market forces. Even a shoddily-disguised manipulation attempt of slaughtering the noble Long Bond failed to force long-term interest rates lower late in the year, which we discussed in "Long Bond Assassinated!". While the brazen scheme appeared to work for a couple weeks, marked by the skull in the graph above, powerful free market forces quickly saw through the Fed and Treasury's smoke-and-mirrors and long-term interest rates have been generally rising ever since.

Even worse for the US economy, mortgage rates are also higher now than they were before the Greenspan Gambit was launched. Higher mortgage rates portend a much slower economy.

Consumer spending drives an amazing two-thirds of the US economy. US consumers are deep in debt but are desperately being recruited by the Fed to spend more money that they don't have, which means more borrowing. The last great bastion of middle-class US consumer wealth is in their home equity. Consumers cannot be seduced into "mining" their home equity and sliding ever deeper into debt for current consumption unless mortgage rates are low enough to lure them into refinancing their mortgages.

We believe that one of the original central stratagems of the Greenspan Gambit was to artificially force mortgage rates lower to spawn a refinancing boom. Almost without fail, when Americans refinance their mortgages they suck tens of thousands of dollars of extra cash out of their homes and use this money to immediately spend on themselves, which is great for the US economy but terrible for the financial health of the American consumer. Theoretically, if the Fed could have enticed enough consumer mortgage refinancing cash out of residential real estate equity, there may have been enough marginal consumer spending to lift the US economy long enough to allow Alan Greenspan to retire in dignity instead of as a miserable disgrace.

Now, with mortgage rates migrating back higher even after the most aggressive Fed easing in history, these bullish hopes and dreams of an explosion of mortgage refinancing-driven consumer spending have been shattered. On the interest-rate front, the primary theater of operations for the Greenspan Gambit, we score it Greenspan one to Free Markets three, a humiliating defeat that will tar Alan Greenspan's reputation forever.

While the primary and most-effective button on the Fed's dashboard of the US economic supertanker is short-term interest rate manipulation, the Fed does also have a far less effective second front for its campaign in both directly creating new money out of thin air and encouraging or coercing banks into creating more money through fractional reserve banking. The problem with the Fed mucking-about in money supplies is they can only safely expand in a debt-driven economy like the current United States. If money supply growth goes negative, new debt cannot be serviced and the debt system falls into a devastating deflationary spiral.

In order to try to avoid the dreaded deflationary debt-destruction spiral, the supplies of fiat and electronic money backed by nothing but confidence have to be perpetually increased. This increase in money supplies is known as inflation, which I have written about in numerous past essays including the recent "Inflation or Deflation?".

Typically, US money supplies increase by about 3% to 6% per year, which is pretty much par for the course in the giant Western Welfare States. In the Great Fed Panic of 2001, however, money supplies abruptly skyrocketed. Using the most conservative possible year-over-year measure (NOT annualized percentages, but absolute percentage growth from one year ago), US money supplies literally exploded in 2001. While some economists will argue that the Fed does not directly control money supplies, no one can dispute the fact that the Fed has enormous influence on money and can direct money supply growth even if the Fed doesn't outright control it.

M1, narrow money, rose 5.9% in 2001. MZM however, which includes currency, checking accounts, and money market fund "cash", rocketed by a breathtaking absolute 20.6% in 2001! This increase is simply mind-blowing in and of itself and is a monumentally inflationary omen. One of the great economic delusions of 2001 was the popular Wall Street myth that exploding money supplies are good for the markets and not inflationary. Relatively more money chasing after relatively fewer goods and services IS the classic definition of inflation! With the US economy only growing by a dismal 0.1% in 2001 while MZM rocketed 20.6%, inflation in 2002 is virtually inevitable.

M3, the broadest measure of the US money supply, roared up an incredible absolute 13.1% in 2001 during the Greenspan Gambit. For comparison, please realize that M3 growth between 1990 and early 2001 averaged "only" 3.8% per year. The Federal Reserve is allowing broad US money supplies to roar ahead about 3.5x faster than the decade-long average and an unreal 131x faster than the growth in the US economy!

Could these mega-inflationary tidings be what is spooking the bond markets? Is this breathtaking money supply explosion the reason why the free markets will not allow long-term interest rates to fall? We believe that the unprecedented money supply ramp during the Great Fed Panic of 2001 is the most likely culprit in explaining why bond investors are avoiding Greenspan and his short-term interest-rate games like an Ebola Zaire outbreak

The score after interest rates and money supplies are taken into account? Greenspan one, Free Markets six.

The so-called "official measures of inflation", the Consumer Price Index and the Producer Price Index, remained tame in 2001 despite the money supply shenanigans. This is not too surprising for a couple reasons, however.

First, money supply inflation always precedes actual price inflation in an economy. Money supply growth is the cause and price inflation is the effect. 2002 is much more likely to bear the brunt of Greenspan's inflationary assault than 2001 since it takes time for exploding quantities of money to work their way into the real economy.

Second, the government agency managing these official inflation stats has huge political incentives to develop mathematical wizardry to low-ball the numbers and obscure reported inflation. The lower the officially reported inflation, the happier the political bosses of the statisticians are and the less money the United States government has to pay out in interest expenses and welfare transfer payments. After the great 2001 money explosion works its way into the real economy, however, inflation will probably become impossible to camouflage even for the mighty mathematical wizards at the Bureau of Labor Statistics.

But, with CPI "inflation" only officially recording 2% and PPI "inflation" actually weighing-in at negative 1.2% in 2001, these are mammoth victories for Alan Greenspan and the Fed as they help disguise the dreadful coming "Inflation Tsunami" for a season. Two big wins for Greenspan and the market manipulators here!

In the commodities arena, the Greenspan Gambit still appears quite successful. Oil, the most important commodity in the global economy, was off almost 21% in 2001. While the Fed doesn't control or even influence oil prices, this is still a huge victory for Greenspan as it puts more dollars in the pockets of US consumers so they can help spend money to keep business profits up and keep the economy from spiraling down into a horrible recession or outright depression.

Gold, the King of Assets and the ultimate inflation barometer, continued to be aggressively and actively capped by official central bank selling. In 2001 reams of additional official evidence were discovered worldwide that strongly incriminate the US Federal Reserve and the US Treasury in both actively managing global central bank gold selling and possibly even illegally liquidating official US gold reserve holdings to cap gold rallies. The fearless freedom fighters at GATA now have discovered literally ten times the amount of evidence that was available in 2000 supporting this frightening hypothesis. Nevertheless, gold was kept mysteriously locked in a tight trading-band almost all year and finished up only a couple percent, another giant victory for the Fed. The moment the gold price bursts free from its shackles and rises significantly, savvy investors worldwide will realize something is very wrong with the dollar and the consequences could be immense.

Trouble is brewing in the gold world, however, and the Fed will have a much tougher time influencing the gold price in 2002. Profits in the Gold Carry Trade, which is essentially the spread from borrowing gold at very low interest rates from central banks, selling the gold in the open market, and then investing those proceeds in short-term US Treasury debt, have been destroyed by the collapsing short-term interest rates. Gold carry profits have plummeted by 80% during the Greenspan Gambit, a catastrophic rout. This is very important for many reasons, not the least of which is central banks can only find willing borrowers for their gold when gold lease rates are low and market interest rates are high. This is not the case anymore. The paltry current sub-1% gold carry profits are not worth the enormous risk of a supply/demand based gold price explosion.

The gold carry trade is dying before our eyes. Soon central banks will lose the crucial conduit of gold leasing for dumping the metal onto the world markets and they will have to resort to outright selling, which is much harder to hide, or quit dumping gold entirely, which means the gold price will soar. At that point, it is "check-mate" for the anti-gold forces!

After interest rates, money supply growth, official inflation measures, and crucial commodities are considered, the Round Two Rate Cut Scorecard puts Greenspan and the Fed at five and the Free Markets at seven.

Alas, however, unfortunately most of the critical variables we have discussed thus far are considered little more than obscure economic arcania by most investors today. For most folks, the Fed rubber meets the real-world road in the enormously important US stock markets.

On January 3 as the first surprise rate cut was celebrated, EVERYONE on Wall Street and the vast majority of the investing world assumed that the US equity markets would finish this year at least 10% to 20% higher since the Fed was throwing the whining equity speculators such a big bone in rate cuts. Today, however, almost 12 months after the opening move of the Greenspan Gambit, in terms of stock prices the rate-cutting spree has been a dismal and catastrophic failure.

The elite Dow 30 is off 6.5% on the year, the huge S&P 500 has bled 12.9%, and the hyper-speculative NASDAQ casino has hemorrhaged another excruciating 20.6% of its value! It is literally impossible to overstate what a devastating psychological blow this is for the perma-bulls!

The whole US financial system and economy are based on pure confidence. Watching the equity markets plunge for the second year in a row even in the midst of the most extreme and aggressive Fed easing in history is tremendously disconcerting and damaging for American investors.

With a system based on little more than faith, there is probably nothing in the world that could have shaken that very faith more in 2001 than finding out that the Fed was and is totally impotent in the face of a post-bubble bust. Just as in the US in the 1930s and Japan in the 1990s, the same easy money and market manipulation that causes bubbles to swell in the first place is not what will fix them or allow them to work their way out of the system. Ever more excess credit is NOT the cure for burst credit bubbles!

Beginning in 2001, and accelerating in subsequent years, the power of the Fed as a force for inspiring confidence in the faith-based financial system has eroded and will erode substantially. It is hard to even imagine the catastrophic damage that Greenspan has wrought by blowing virtually all the Fed's ammo in a single year but with little or no tangible success evident in the US equity markets. These three stock market losses for Greenspan are absolutely ruinous!

Last but not least, and maybe most importantly of all, with Greenspan and the Market Manipulators way behind the Free Markets by five to ten in the Round Two Rate Cut Scorecard, the US dollar must be considered.

In classical economic theory, the value of a currency on the world markets is primarily determined by two things, the interest rate the sovereign government-debt denominated in that currency pays to foreign investors and the expectations of future inflation that will erode the wealth of foreign investors. The whole colossal mess in Argentina right now will make a classic case study for decades to come about what happens when foreign confidence in a currency and government's financial dealings is lost through gross mismanagement.

In 2001, the US dollar had a huge year, roaring up 7.9%. In the face of plummeting interest rates, unprecedented money supply growth, and negative real returns for bond investors, this gain flies in the face of all economic and financial theory. The reasons for the dollar's current unnatural strength are complex and legion, and are best left for a future essay dedicated to that subject alone. But, with a strange fortuitous convergence of rare events including the world recession, the horrible mismanagement of the Japanese bust (ominously, the Japanese authorities tried exactly what Greenspan is now trying in the US but failed!), the birth of the Euro, the capping of the gold price, and the willingness of the US consumer to plunge further into debt to buy foreign-made goods, the dollar remains strong even as economic theory says it should be plummeting to earth. This is an immense victory for Greenspan and the Fed in 2001!

But, like all unnatural market events (witness the collapse of the great NASDAQ bubble of 2000), the dollar's unexplainable strength will too soon meet its end. All kinds of elite global financial organizations are declaring that a 20% to 30% fall in the US dollar's price on the world markets is long overdue and imminent. While Greenspan dodged the dollar bullet in 2001, we don't think he will be so lucky in 2002. All economic actions have consequences, and the Fed slaughtering the return on short-term US dollar-denominated Treasury investments as well as potential enormous inflation looming bode very ill for the fortunes of the dollar in the coming year.

Net net, as the dust begins to clear near the one-year anniversary of the opening salvo of the Greenspan Gambit, the Free Market forces are thrashing the Market Manipulators at the Fed by ten to six. Indefinitely manipulating markets has always been a losing game in history, and it continues to be an impossible task today.

Watching the Greenspan Gambit chickens come home to roost in 2002 should be both fascinating and frightening.

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