Weekly Market Commentary, June 4th 2008
               Eleven weeks ago (March 18th), I wrote an article decrying the Federal Reserve’s (Fed) handling of the economic crisis. My argument was that although the Fed had taken every step imagined to unlock the credit market and bolster the stock market, little had been accomplished. Having just reduced their overnight lending rate 75 basis points (bp), the Dow Jones Industrial Average (DJIA) staged a 420 point rally. However, my concerns were that the Fed was running out of options to revive the equity markets, had destroyed the dollar and bolstered commodity prices with their constant intervention. At that time, I asked why the current monetary stimulus would save the stock market and why was not anyone concerned with the havoc higher commodity prices and a weaker dollar would have on the average American.
               At the time, my concerns seemed unfounded. The DJIA closed that day at 12,392. Over the next seven weeks, the Fed would reduce interest rates an additional 25bp and the DJIA would close above 13,000. Most continued to ignore escalating commodity prices and a weakening dollar. After all, the Fed had managed to boost the DJIA nearly 5%, prevented a market meltdown by arranging for JPMorgan to acquire Bear Sterns and taken increasingly creative actions to unlock the credit markets. Having accomplished these goals, why worry that oil prices had increased 25%?
               As I have identified many times, the key when evaluating any investment decision is to look at things over proper time periods. What initially seemed like an unnecessary concern was actually a prudent assessment of the risks in the marketplace. The Fed’s easy money policy had increased inflation risk. Eventually the market realized this risk and began pricing in the possibility. As a result, the DJIA currently trades at a price below where it closed 11 weeks ago. Despite a break in prices, oil is still 15% higher and the dollar remains relatively unchanged versus other currencies. More worrisome, the KBW Bank Index is 11% lower and the Dow Jones Broker Dealer Index is unchanged. Further, if we look back to when the Fed began reducing interest rates in response to the credit crisis (9/17/07), the DJIA has dropped 8%, the Broker Dealer index has lost 23%, the Bank index has declined 31% and the CRB commodity index has risen 28%.
               Having pushed their overnight lending rate to 2%, we are now in the position I feared. The Fed has expelled a great deal of ammunition and creativity in addressing the financial crisis, yet has accomplished little. The US economy is reliant on borrowed money to grow yet credit is unavailable to most borrowers. Further, the weak dollar and higher commodity prices that have gnawed at consumers have finally drawn the attention of Fed chairman Ben Bernanke. With yesterday’s acknowledgement that a weak dollar is leading to inflationary pressures, the likelihood of further interest rate reductions has diminished. One must remember that the value of the dollar is under the leadership of the US Treasury, not the Fed. Bernanke, by mentioning his concern over the dollar, has injected himself into a discussion that prior Fed chairman avoided. It is hard to imagine how Bernanke could have made these comments and still plan to reduce interest rates in the future. The logical assumption is that further rate reductions will not be forthcoming and that the next move from the Fed will be to push rates higher.
               As I asked in my article on March 18th, the key question is, “where we go from here?” The immediate reaction to Bernanke’s comments has been a stronger dollar and weaker commodity prices. While short term volatility will remain in those markets that have become most reliant on easy money (i.e. - the banks and brokers which continue to selloff), we must also consider the long term ramifications of the Fed’s actions. Personally, I have never been comfortable or advocated the current approach to managing interest rates. By constantly reducing interest rates in the wake of every financial crisis, the Fed has prevented the economy and asset markets from ever reaching equilibrium. The result has been one bubble after another. As we are now learning, when the bubbles stop blowing the cleanup can be painful.
               Assuming the Fed leaves interest rates constant, we should see a steep yield curve and slower growth. Banks will have the ability to lend money at larger spreads which allows them to rebuild their balance sheets.  Capital will begin flowing to the businesses that are strong and produce returns for shareholders. Marginal players in weak industries will see their access to funds diminished and will be merged with stronger partners. Dominant players in strong industries will grow the value of their franchise as barriers to entry increase. Consumers will begin focusing on restoring their creditworthiness and strengthening their personal wealth. All in, a movement away from slashing interest rates to prop up the stock market will result in a stronger economy that will create wealth and efficiently allocate capital in the future.Â
                Unfortunately, the transition in that direction will be painful. Even if the recession is over and the worst behind us, the lack of lending will result in subpar growth over the next few quarters.   This lack of growth with no true catalyst will make it difficult for the markets to move higher. When this transpires, expect the calls for Fed action to be loud and constant. From there, we will see if Bernanke has the persistence to create an economic environment where risk is priced and returns are reasonable or if he will bow to the pressure, follow Alan Greenspan’s lead and provide a short term solution with serious long term consequences.
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Sean,
You are bang on. We have an academic for a Chairman, and not someone in there with a traders mentality. Many of us were screaming, just as you accurately were - that inflation was going to go through the roof. Why weren’t they soaking up USD’s on the Forex market from the international field? I could go on and on here. But you summed it up well with:
As we are now learning, when the bubbles stop blowing the cleanup can be painful.
Precisely the point. Exactly. Sooner or later, the bubbles stop blowing up - because the bubbles cannot be created any longer. If the pain becomes severe enough - we need someone to have the guts to pull a Paul Volcker move. The question is - does anyone have the guts to do that today - or is it necessary? I think time will tell. If they can’t get a handle on inflation? Then it will be absolutely necessary. Painful, but necessary, and can only lead to future growth.