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Henry To

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is…

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A Quick Word on the Discount Rate and the "Ben Bernanke Grand Experiment"

Dear Subscribers,

Note: For those would like to learn more about Modern Portfolio Theory and the latest trends in the financial markets, please read our latest book review of Peter Bernstein's latest work, entitled "Capital Markets Evolving."

Let us now begin our commentary by providing update on our three most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

As of Sunday evening on August 19th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link). There is a reason why so many financial professionals get burned out - and the last ten trading days were a testament to that. The big news was Friday's surprised 50 basis point discount rate cut by the Federal Reserve - something which we had not anticipated (although this author had been discussing that the Fed Funds rate should be cut before this month is over) - but which is now very clear in retrospect. As subscribers may or may not know, the Federal Reserve's "Discount Window Lending Program" was revamped substantially during the middle of 2002 - whose purpose was to "improve the functioning of the discount window and the money market more generally." Among its many changes, the amendment sought to:

  1. Increase the interest on "primary credit" (loans available at the discount rate to financially-sound institutions) to a rate about short-term market interest rates, including the Fed Funds rate - which historically has been approximately 50 basis points or so above the discount rate. The goal of the amendment was to increase the primary discount rate to a level approximately 100 basis points above the FOMC's then-prevailing target for the Fed Funds rate.

  2. Lessen the administrative burden on financial institutions to borrow from the discount window, by not requiring financial institutions to have exhausted other means of borrowing before turning to the Fed, and allowing credit-worthy institutions to borrow from the discount window with minimal paperwork.

In instituting the changes, the Federal Reserve's intention was first, to eliminate the incentive for financially-sound depository institutions to do a "carry trade" by borrowing from the discount window (at a discount to that of the Fed Funds rate), and in turn, lend the proceeds to the Fed Funds market. This "carry trade" was hugely discouraged (and rightly so) by the Fed and that is one reason why all financial institutions - prior to the 2002 amendment - had to jump through a lot of hurdles and red tape before they could get financing from the discount window. This also, in turn, had created a lot of disincentives for institutions to turn to the Fed in times of crisis, even though their needs may be legitimate. By increasing the discount rate to 100 basis points above the Fed Funds rate, the Fed - with one stroke - had destroyed any potential carry trade "arbitrage" between the discount window and the Fed Funds market. At the same time, this allowed the Federal Reserve to greatly eliminate most of the checks and balances before financial institutions can turn to the discount window - thus rendering the Federal Reserve a more effective financial mechanism for banks and other sound financial institutions during troubled times.

In the Fed's words: "A substantial spread would encourage depository institutions to borrow only to meet short-term, unforeseen needs. Too wide a spread, however, would mean that the federal reserve funds could, at times, rise to undesirably high levels about the FOMC's target ... If, as is intended, the primary credit facility significantly reduces the reluctance of depository institutions to use the discount window, the Federal Reserve should be able to cap the federal funds rate near its target during a crisis by reducing the primary discount rate to a level close to the target."

Subscribers who have the time and the inclination should read the Federal Reserve July 2002 bulletin for more clarification. For those who don't (and that means virtually all of our subscribers), this much is clear: The latest move by the Federal Reserve to lower the discount rate by 50 basis points was designed as a way to cap the Fed Funds rate - since the Fed Funds rate had been moving anywhere from 4% to over 6% in the last six trading days. The cut of the primary credit rate to 5.75% should now mean that the Fed Funds rate would never move above 5.75% - as folks who can't borrow from the Fed Funds market would now be able to borrow from the discount window itself, assuming that they have the necessary credit rating (if not, they can always get "secondary credit" from the discount window, at a rate of 50 basis points higher, or 6.25%). This would also mean that credit-worthy banks can borrow from the Fed at 5.75% and arbitrage at the Fed Funds market should the Fed Funds rate move above 5.75% at anytime. In essence, this latest move was merely designed to BOTH cap the Fed Funds rate and to cap the volatility of the Fed Funds rate - it does not mean that the Fed has really eased - it is merely making sure the financial system remains "orderly." The Fed is trying to do as little as possible. Of course, at some point over the next few weeks, I believe the Fed will eventually ease - but most probably not until September 18th (a whole one month away) at the earliest, unless we see more disruptions in the financial markets in the coming weeks.

For those who have been looking for a "bailout" ala the "Greenspan Put," they will not find it in the latest move by the Federal Reserve. It is important to note that Ben Bernanke is still trying to establish his own "footprint" on the Federal Reserve, and probably, more importantly, prove that he can be tough on inflation and to dispel his unfortunate (and unfounded) reputation as "Helicopter Ben." I had previously discussed this in our October 27, 2005 commentary entitled "The Ben Bernanke Grand Experiment." Even though that commentary is now nearly two years old, I believe that many points that I made in that commentary are still relevant - and I would highly recommend subscribers to go back and read that commentary, especially in light of recent events.

For those who want to read further on the Fed's course going forward, I would also highly recommend reading the book "Inflation Targeting: Lessons from the International Experience" which was co-written by Bernanke and several other authors in 1999. One is not qualified to be a "Fed Watcher" until one has read this book, along with Bernanke's work on the Great Depression. For those who do not have time to read "Inflation Targeting:, I will now highlight a couple of take-away points that I feel is essential from the book. Quoting Bernanke:

First, the increased emphasis on controlling inflation arises not because unemployment and related problems have become less urgent concerns, but because economists and policy-makers are considerably less confident today than they were thirty years ago that monetary policy can be used effectively to moderate short-run fluctuations in the economy, except perhaps fluctuations that are particularly severe or protracted. Further, most macroeconomists agree that, in the long-run, the inflation rate is the only macroeconomic variable that monetary policy can affect. When monetary policy-makers set a low rate of inflation as their primary long-run goal, to some significant extent they are simply accepting the reality of what monetary policy can and cannot do.

Thirty years ago, policy-makers and most economists supported "activist" monetary policies, which were defined as policies whose purpose was to keep output and unemployment close to their "full employment" levels at all times. Supporters of activism believed that there was a long-run tradeoff between inflation and unemployment, known as the Phillips curve. According to this view, the monetary authorities could maintain a permanently lower rate of unemployment by accepting some degree of inflation, and vice versa. At about the same time, large econometric models of the U.S. economy became available that promised to give policy-makers the quantitative information they needed to implement economic stabilization policies. To many economists and policy-makers, it seems possible that actively managed monetary (and fiscal) policies could be used to maintain maximum employment pretty much all the time. That happy outcome was not to be. The business cycle did not die a quiet death in the 1960s, as had been predicted by the more optimistic proponents of activist policies. Indeed, the recessions of 1973-74 and 1981-82 were the most severe of the postwar period. Nor did inflation vanish.

In conclusion, I believe that going forward, not only did the above make clear that the "Bernanke Fed" would adopt a policy that will be steered towards "inflation-targeting," but given that the Fed does not believe in adopting an activist policy (targeting unemployment or GDP growth), the Bernanke Fed would be more reluctant to ease rates without a corresponding decline in the core CPI, unless the financial system itself comes "under attack." While there is a good chance that the Fed Funds rate will also be cut in the days ahead, such a move will most probably not come until the next policy meeting (September 18th) at the earliest. Moreover - with the benefit of hindsight - it is now apparent that the Greenspan Fed lowered rates much more than they should in combating the deflationary effects of the technology bust 5 to 6 years ago, and given that global economic growth is still strong, there is now no reason to for the Fed to drastically ease rates (such as to 4% or below) going forward, unless 1) the core CPI decreases in the coming months, 2) leading indicators (such as the stock market, housing starts, unemployment initial claims, etc.) all start pointing toward a recession.

"Nothing is Obvious" Redux

In the "nothing is obvious" department, I noticed that many websites and blogs have noticed the record number of new lows achieved last Thursday - and why that this 1) constituted a severe oversold condition, and 2) meant that we are now bound to make new all-time highs in the major indices going forward. In doing so, they have often cited that on the three prior occasions that this has occurred (namely October 19-20, 1987, August 23, 1990, and August 31, 1998) over the past 20 years, the market has always gone on and rallied ahead in the days and weeks ahead, and as such, now is the time to go heavily long in the U.S. stock market. More specifically, the daily NYSE high-low differential ratio (number of new highs minus number of new lows on the NYSE divided by the total NYSE issues outstanding), hit a reading of negative 33.93% last Thursday - a level not seen since August 31, 1998, when it hit a reading of negative 32.71%.

Following is a chart showing the NYSE High-Low Differential Ratio from March 1965 to the present:

Daily NYSE High-Low Differential Ratio vs. the S&P 500 (March 1965 to the Present) - Over the last 20 years, there has only been three instances (not including last Thursday) where the NYSE High-Low Differential Ratio had hit a level of -30% or below...

As can be seen on the above chart, there have been many instances since 1965 when an oversold reading such as what we got last Thursday resulted in more declines going forward. Obviously, the US$64 billion question now is: What is up ahead?

In the short-run, there is no doubt that the market was oversold on Thursday (and still is to some extent), and therefore, that the market should continue bounce higher over the next few days. In the longer-run, however, the picture is much more uncertain. First of all, while that has certainly been true in the last 20 years, it is to be noted that three occurrences over the last 20 years is hardly of statistical significance. Second of all - prior to the October 19, 1987 reading - there have been many more instances since 1965 when this reading had reached similar levels - only to see lower lows in the stock market going forward, sometimes by a wide margin. Moreover, during the times when such readings have resulted in lower markets, they have occurred very soon after the peak (such as late July 1969, or May 1973), similar to what is occurring today. In other words, as opposed to be a "bottoming indicator," this latest "oversold reading" in the NYSE High-Low Differential Ratio is merely a reflection of significant downside breadth in the current markets - a picture which is not too surprising given the strong breadth (in all sectors, market cap segments, and in both growth and value stocks as well) we have witnessed in the stock market ever since the current cyclical bull market began in October 2002.

Following is a table showing the dates of historical sub (30%) readings in the NYSE High-Low Differential Ratio - along with subsequent 1, 3, 6, 9, and 12-month performances - from March 1, 1965 to the present:

NYSE High-Low Differential Ratio from March 1, 1965 to the present

I apologize for the "busyness" of the above table, but I believe the above table is the best way to present my observations. Firstly, I want to again emphasize that there has never been a case which has satisfied these two following conditions 1) a sub (30%) reading had occurred so soon after a major peak in the S&P 500 (in this instance, July 19th, or just four weeks after a major peak), and 2) a new high in the stock market soon afterwards, or even a year from now. The two closest scenarios where this has occurred is late June 1965, and late March 1980, when we got a sub (30%) reading in the NYSE High-Low Differential Ratio approximately six weeks after a major peak - and when the market went on to make new highs soon afterwards.

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