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Trading Lessons

Financial Markets Manipulation - The Rise of the Bernanke Put Option?

Stock-Markets / Market Manipulation Mar 23, 2007 - 10:39 AM GMT

By: Money_and_Markets

Stock-Markets

Mike Larson - Did you see that monster rally on Wednesday afternoon? The one that sent the Dow up more than 150 points in the blink of an eye? If you're wondering what caused it, I have an answer for you …

Federal Reserve Board Chairman Ben Bernanke is trying out the “Greenspan put!”

Alan Greenspan, our last Fed Chairman, was notorious for solving market crises by lowering interest rates. In fact, the Wall Street crowd even dreamed up a nickname for this — the Greenspan put.


The name refers to put options since investors often use them to minimize downside risk. The idea was that Greenspan's easy money policies would always be there to help the markets stabilize. Thus, with Greenspan at the helm, your risk was always limited!

Throughout the 1990s, investors were able to do extraordinarily stupid things with their money because they knew Greenspan would always be there to save their hides in the event of a blow-up. Want examples?

Event #1: In December 1994, Orange County, California filed for bankruptcy. It was the biggest municipal bankruptcy in recorded U.S. history, and it caused a significant meltdown in the municipal bond market.

Greenspan's response: Greenspan and his Fed buddies stopped raising short-term interest rates shortly after the crisis broke. A couple of months later, they started cutting rates .

Event #2: In the summer of 1998, the gun-slinging hedge fund Long-Term Capital Management watched in horror as it lost billions of dollars from bad bets. Stocks plunged and Treasury bond prices soared as investors ran from risk.

Greenspan's response: Despite the fact that unemployment was at 4.5% and falling and core inflation was running at a relatively high 2.5%, the Greenspan Fed responded by slashing interest rates. Three rate cuts — one each in September, October, and November 1998 — flooded the economy with easy money. That, in turn, set the stage for one last-hurrah …

Event #3: U.S. stock markets, particularly the Nasdaq, soared to new highs in the midst of ravenous speculation. Of course, we all know how that ended — the dot-com bubble started popping in early 2000.

Greenspan's response: Once again, Greenspan went to work. He cut and cut, driving the federal funds rate down from 6.5% to a puny 1%.

Reasonable people can disagree whether some of Greenspan's cuts were justified. But in my view, the record shows that he took things too far again and again. He overreacted to short-term market dislocations. He never really let speculators get punished. And he never let economic recession work its cleansing power.

Moreover, Greenspan would swoop in with a fresh flood of easy money no matter what kind of data he had on inflation, employment, growth, or virtually everything else.

And it looks like Ben Bernanke is following his lead. Let's fast-forward to this week …

All Indicators Point to Higher Inflation, Yet Bernanke Is Caving Anyway!

The Fed's primary mission is to fight inflation tooth and nail. And the latest inflation stats have been anything but tame:

  • The Producer Price Index, which measures inflation at the wholesale level, surged 1.3% in February, more than twice the market forecast.
  • The “core” PPI, which excludes the impact of food and energy prices, jumped 0.4%.
  • Core intermediate goods and core crude goods prices, which indicate inflation at earlier stages of production, rose at the fastest pace in several months.
  • The Consumer Price Index climbed 0.4% in February, pushing the year-over-year inflation rate up to 2.4%.
  • And the year-over-year core inflation rate rose to 2.7%. Know what the Fed's unofficial target for inflation is? Between 1% and 2%!

Those numbers are all snapshots of inflation. But the Fed also watches real-time inflation indicators. An important one is the difference between the yield on 10-year Treasury Inflation Protected Securities and the yield on regular 10-year Treasury notes. When this “spread” is increasing, investors are becoming more fearful about inflation.

As you can see from my chart, the spread has been rising for several weeks now. It just hit 243 basis points, or 2.43%. That's the highest since September. In other words, the market is saying loud and clear that inflation pressures are building!

Given all the evidence, you'd think the Fed would come in guns blazing, leaving absolutely no hope of a rate cut. Instead, their language has gotten more wishy-washy …

On January 31, they said:

“The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

But on March 21, they said:

“Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

Read quickly, these two statements sound almost identical. However, note that the Fed went from talking about “additional firming” to potential “policy adjustments.” Firming is code for hiking rates, while “policy adjustments” could mean any action.

Put another way, the Fed opened the door to a potential rate cut! Why?

Bernanke and Company Are Scared, Scared, Scared …

In a word, the Fed is worried about housing. They know that a massive tech bubble was replaced with a massive housing bubble, which is now popping. They're scared that subprime mortgage losses will cause banks to curtail other forms of lending … scared that the broader economy will follow housing into the toilet … and scared that the recent stock market hiccup will turn into a stock market rout.

I feel for the true victims from this housing bust. I really do. Lots of people were brainwashed into thinking house prices would go up forever. And lots of lenders just plain ripped people off.

At the same time, a huge chunk of the run-up in home prices was fueled by dumb investors doing dumb things with money borrowed from dumb lenders. If the Fed bails them out with yet another dose of easy money, it's just going to continue the vicious cycle of bubbles and busts.

Look, I hope I'm wrong about Bernanke. I hope he's not going to start offering the market “Bernanke puts” whenever things turn sour. I hope he stays focused on inflation and lets the markets sort themselves out.

But I don't like the sound of that door-opening comment. I think it shows the Fed's true intentions — to lower rates whenever investors get into a little trouble.

A Bernanke Put Could Have Two
Important Market Implications

For starters, the Fed's new approach is causing the yield curve to return to normal. In plain English, that means short-term interest rates are now falling below long-term rates. [Editor's note: For more information on the yield curve, see “ Fed Chairman Wrong Again? ”]

That's an important signal! It tells us that bond traders are afraid the Fed will sacrifice its long-term, inflation-fighting credibility in order to try and “save” housing. They're buying short-term notes, which will benefit from a rate cut. And they're selling long-term bonds, which will get whacked if the Fed lets inflation get out of hand.

I can't argue with that strategy. In fact, I've been telling you to stick to short-term Treasuries for a long time. If you're still holding long-term bonds, don't wait. Dump them now! The long bond already got pasted for a full point on Thursday, and more downside could be dead ahead!

Plus, the dollar will likely continue to weaken if Bernanke cuts rates. Several foreign central banks are still hiking interest rates, some aggressively. Therefore, investors will pull money out of the dollar and switch into other, higher-yielding currencies.

It's already happening. The dollar is trading right around its lowest level versus the euro since March 2005. Relative to the Australian dollar, it's at its lowest level since late 1996.

In my opinion, the investments that are most likely to benefit from a continued decline in the dollar are international bonds, gold, and high-yielding foreign stocks.

Until next time,

by Mike Larson

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.MoneyandMarkets.com


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