Another masterstroke by the tactical genius of monetary policy, or a desperate effort to stop a 50% ...
Another masterstroke by the tactical genius of monetary policy, or a desperate effort to stop a 50% slide in the Nasdaq from becoming a freefall?
It's tough to question Federal Reserve Chairman Alan Greenspan's abilities in managing the world's biggest economy. But it's similarly hard to ignore the worry that last week's surprise Fed rate cut is an example of what economists call moral hazard. That's the idea that taking big financial risks is safe because central banks will bail out investors if things go awry, and that the perceived existence of that safety net encourages risky behaviour.
In relation to the US stock market, analysts express the concept of moral hazard as the "Greenspan Put Option." A put option allows the holder to sell an asset at a predetermined price, regardless of its current market value. The Fed's apparent willingness to intervene on behalf of the stock market gives investors a put to protect their equity investments.
So while the "Greench" may have rescued Christmas by cutting rates, the long-term effect may be to fool investors into believing that the stock market is a one-way bet. "The value of your investments may go down as well as up, but the Fed will step in and make it all better," as the advertising disclaimer might say.
The Fed cut its benchmark interest rate by half a point to 6%, the first time it has cut rates between meetings since the Russian debt default in October 1998. In the aftermath of the move, the Nasdaq Composite Index posted a record 14% gain. The value of US stocks, as measured by the Wilshire 5000 Total Market Index, soared by $708bn.
The dollar posted its biggest gain ever against the euro, climbing 2.5% to 92.71 cents per euro. The benchmark 10-year Treasury bond had its biggest one-day drop since July 1996, falling almost two points in price to 104 14/32.
The market picture looks a bit different in the cold light of the following European morning, however. On the morning of 4 January the 10-year note rallied to 105 6/32, the dollar was back down to 94.92 cents per euro, and the futures market was indicating a drop in US stocks, with the March Nasdaq contract down 65 to 2464.5.
Two big worries are plaguing investors and traders. There's the "what does Greenspan know that we don't?" concern. Everyone knows the economy is slowing; the rate cut implies Greenspan fears it could tip into recession. But there's also a worry that the Fed is setting monetary policy based on the needs of the US stock market rather than the wider economy. While the two are inextricably linked, steering the stock market and piloting the economy aren't the same thing.
In a February research note, Paul McCulley, a portfolio manager at Pacific Investment Management Co. in Newport Beach, California, outlined the problem.
"The record of the Greenspan era strongly supports the proposition that Greenspan has written equity investors a re-liquefaction 'put' option struck below the market," McCulley wrote. "The equity market has become a bubble, inflated with 'too big to fail' Fed ether."
In an accompanying chart, titled "Stocks' Mantra: When Stuff Happens, the Fed Eases," McCulley runs a line showing the almost inexorable ascent of the S&P's 500 stock index, accompanied by key cuts in the Fed funds rate‹after the October 1987 stock market slump, between 1990 and 1992 during the crisis at US savings & loans institutions and the Gulf War, in 1995 as the Mexican peso plummeted, and in late 1998 when Russia blew up and hedge fund Long-Term Capital Management went bust.
That's not to say there aren't compelling economic reasons why the Fed should currently be easing monetary conditions. The National Association of Purchasing Managers survey earlier last week showed manufacturing slumped in December to its weakest level since the end of the last US recession. Still, there's no guarantee that the Fed's balm will succeed in soothing either the US stock market or the economic outlook anytime soon.
Mark Gilbert in the Bloomberg London newsroom
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