Pivotal Events -- Excerpt of the Edition Published September 7, 2006
"The Fed, which last month left interest rates unchanged for the first time in two years, is the main source of the current [stock market] optimism." - WSJ, September 5, 2006
This goes along with the glowing conclusions by David Wolf, an economist and strategist with Merrill Lynch. When the governor of the Bank of Canada did not change the administered rate earlier in August, the Financial Post headlined "Standing Pat Was the Right Call".
Strategist Wolf raved that the governor's non-move was "Looking Like a Genius".
Well, the way it worked in 2000 was that during the summer, as short rates were still rising, the consensus was very worried about the next increase in administered rates.
As we wrote then, throughout most of financial history rising rates mean that the boom is still on. The time to worry is when market rates of interest start down. Along with the usually concomitant turn to steepening of the yield curve, this indicates that demand for funds to speculate with is diminishing.
After all, inversion has always been driven by the urge to speculate.
So the consensus now is that the end of the Fed's or any lesser central bank's rate hikes is a mark of genius and is good for the stock market. This is nonsense and suggests that when an economist is elevated to the head of a central bank it gives new meaning to the concept of artificial intelligence.
First of all, at the climax of the biggest bubbles going back only to 1873, changes in administered rates by the senior central bank have followed the change in short-dated market rates of interest - usually by a few months.
For example, treasury bill rates turned down in September, 2000 and the Fed dropped the administered rate in the first week of 2001. In 1929, short rates started down in June, 1929 and the Fed raised the administered rate to 6% in early August. Then that extraordinary decline started.
The other irony is that academics ever since have argued that the hike caused the 1929 crash and the depression. In January, 2001 when the Nasdaq had lost over $3 trillion in market cap, op-ed pieces by different writers laid the blame on the Fed's last rate hike.
So this is how the behaviour pattern works. Fully astride the bull market, the consensus in real time celebrates the end of administered rate increases as a plus. Then, when the market is down substantially, the consensus then lays the blame on the last rate hike. Chagrin always seeks a scapegoat.
On this go around, the Fed is lauded for the last of 17 rate hikes of a ¼ point each and, as quoted above, the end of this has prompted "optimism" or, in the case of the Bank of Canada's non-move, "genius".
The next level of irony is that on the biggest booms the last rate hike has been followed by a severe contraction and the most relentless declines in short market rates, with the administered rate in close pursuit.
The Most Substantial Interest Rate Plunges In History
|LAST HIKE||RATE||STOCK MARKET||LOW RATE||STOCK MARKET LOW|
As the stock market began to slide in September, 2000, some within the status quo crowd discovered that they had been had. The adamant faction found encouragement with the immediately circulated notion that the Fed would lower interest rates and that would reignite the boom.
James K. Glassman was using the WSJ's op-ed pages to promote his personal revelations that the Dow would soar to 35,000 and, in December of that fateful year, we concluded that "Market forces will permit the Fed to lower administered rates. That's frequently until the business and stock market contraction ends."
Of course, the theory was that a bubble was an event created and managed by policymakers and that it could readily be turned back on by a brilliantly timed rate cut.
Throughout all of recorded financial history, short-dated market rates of interest have increased during a boom and plunged during the consequent contraction. The senior central bank was able to materially change the administered rate in 1825 and the record is that at cyclical turns (either up or down), it lags the reversal in market rates of interest.
Beyond being merely ironical, the popular theory is a profound blunder. The first level is the unsupportable assumption that the senior central bank can and does make the major changes in interest rate direction - no, it follows.
The second level of folly can't even get the direction of major events right. Booms have never been reignited by declining rates, but contractions have always been accompanied by declining short rates for treasury bills, or equivalent, in the senior currency.
An explanation of how personal revelations about what markets ought to do has become official dogma and could be the subject of an essay entitled "Mother Nature Trumps Keynesian Whims Every Time".
In the meantime, 3-month dealer commercial paper rates reach a high of 5.44% on July 25 as the T-Bill rate reached 5.12%. So far, the lows have been this week's 5.29% and 4.96% respectively.
More importantly, treasury curve inversion (10s to 2s) reached -10 bps on August 28 and has steepened to 0 bps.
At previous cyclical peaks, and although only modest, this change has indicated that the contraction was inevitable.
Stock Market: Since early in the year, our theme has been that market forces were setting up a cyclical peak for the stock market.
One indicator was that the lesser exchanges had blown out in November and the collapse always fed into the senior exchange. The representative Dubai stock market crashed in February.
In the meantime, New York rallied up to what soon appeared as a cyclical peak in early May. The cyclical aspect was indicated by our long-time work on the gold/silver ratio.
In March, it looked like the precious metals would zoom to a climax, in which case the change in the ratio from going down to up would likely signal the top of that mania by three weeks and, in turn, this would soon be followed by the peak in base metal speculation. The latter is usually integral to the peak in the stock market as "every bull market has a copper roof".
As it turned out, the gold/silver ratio reversed on April 19, which indicated that the top would be in the week centred upon May 10. The key highs are tabled:
|MAY 5||MAY 8||MAY 9||MAY 10||MAY 11|
|DJIA||Base Metals |
The action since (nickel is exceptional) has the appearance of a cyclical top, with some of the key highs being tested now.
Lately the stock market is fitting a ChartWorks pattern that had to reach a certain upside momentum by August 11. This was a "make or break" requirement, so it didn't "make" it.