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Seven Years Later: What Does the Fed Know?

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  • Charlie Bilello

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“This is about Bernanke. He has to be on that [Bear Stearns] call. Bernanke needs to open the discount window, that’s how bad things are out there. Bernanke needs to focus on this. Alan Greenspan told everyone to take a teaser rate and then raised the rate seventeen times. And Bernanke is being an academic. It is no time to be an academic. It is time to get on the Bear Stearns call. Listen, open the darn Fed window. He has no idea how bad it is out there. He has no idea! He has no idea! I have talked to the heads of almost every single one of these firms in the last 72 hours, and he has no idea what it’s like out there. None! And Bill Poole has no idea what it’s like out there. My people have been in this game for 25 years and they’re losing their jobs, and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing! I have not seen it like this since I went five bid for a half a million shares of Citigroup and I got hit in 1990. This is a different kind of market, and the Fed is asleep. Bill Poole is a shame. He’s shameful.” – Jim Cramer, August 3, 2007

It’s hard to believe that it’s been seven years since the epic Cramer rant of August 2007. In my view, it was one of the most entertaining and fascinating pieces of financial television that you will ever see (click here for clip). The timing could hardly have been better.

It was Friday, August 3, 2007, two months before the ultimate stock market top. The S&P 500 had just closed below its 200-day moving average for the first time in a year, but was still up over 1% YTD.

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Financials were telling a much different story than the broader market as the start of the housing collapse had already begun. The largest financial firms had significant exposure to securities predicated on the belief, shared by the Fed and chairman Bernanke, that on a nationwide basis “housing prices never go down.” That belief was soon to be tested.

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“As Bad as I’ve Seen it in 22 Years”

Bear Stearns stock was plunging after a conference call was held to address concerns stemming from a rating agency action. Standard and Poor’s had changed its outlook for the firm’s bonds to “negative” from “stable.” Sam Molinaro, Bear Stearns’ CFO, compared the last six weeks in the market to the shocks of 1987, the Asian and Russian debt crises of the 1990’s, and the dot-com collapse. “These times are pretty significant in the fixed-income market,” he said. “It’s as bad as I’ve seen it in 22 years.”

Cramer was not happy with the call, saying: “Memo to Bear Stearns: you gotta adopt a Henry Ford attitude here, which is never explain, never complain. And they didn’t do that. You keep your mouth shut during this period, you don’t say a thing…I don’t want to create fear, I like Bear Stearns very much but I think that at this stage, this is not a good call. They shouldn’t have done it. And they should’ve just said you know what, we’re doing well and don’t say another thing.”

Cramer would go on to say that the Fed knows “nothing” about how bad the market environment was, imploring Bernanke to stop being an “academic” and to open the “Fed window.” He also went after Bill Poole, chairman of the St. Louis Fed, likely in response to Poole’s recent comments on the Fed’s role in the market. Poole had said that the “Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment or when financial market developments threaten market processes themselves.”

Cramer either disagreed with Poole’s hands-off theory or believed that financial market developments were already threatening “market processes.” In either case, he was adamant in saying that lower rates were necessary.

A month later, the Federal Reserve would comply with Cramer’s request, cutting the Federal Funds Rate from 5.25% to 4.75% on September 18, 2007. The Fed would continue cutting rates until December of 2008 when they moved the Fed Funds Rate down to 0%.

Cramer was prescient in his assessment of how bad things were in August 2007, which was in sharp contrast to the Fed’s still rosy outlook. What he and most other market participants likely did not appreciate was that lowering interest rates could not prevent what was to happen next. For it was not simply a liquidity issue; it was very much a solvency issue. Indeed, the Fed lowered the Funds rate from 5.25% to 0% and the S&P 500 declined 57% during that time period. If cutting rates were a panacea, surely this would not have happened.

Seven Years Later: What Does the Fed Know?

The Fed Funds Rate still stands at 0% today, more than five years into the economic recovery that began in June 2009. Financial conditions have normalized, deflation is no longer a legitimate concern, equity markets are at all-time highs, and yields on risky debt are at all-time lows. Why in the world is the Fed maintaining such an aggressive policy stance in spite of these facts? “They must know something” is the common refrain. With the unprecedented boom in all asset prices, market participants are equating short-term market performance with long-term economic insight.

Indeed, the same organization that missed (and whose policies encouraged) the internet and housing bubbles when they were right before their eyes is now being credited with having unique foresight into the future. I have a slightly different view.

Jim Cramer was correct. The Fed knew nothing about the health of the economy in August 2007 and from all the available evidence I can only conclude they know even less in August 2014. They maintain that quantitative easing and 0% interest rates are for the good of the economy but ignore evidence to the contrary that this has been the slowest economic growth and weakest wage growth recovery in history.

 

Chart of Weakest Post War growth US

The Fed’s response is that they simply “need to do more.” Perhaps a fourth round of QE and another year of 0% interest rates will do the trick. But as I questioned in a recent piece, do more at what cost?

The Fed will never admit to it, but what they really do know a lot about at this point is not the economy, employment or real wages. What they know a lot about is how to blow bubbles. Indeed, they have likely already created the third financial bubble in the last fifteen years. They pretend to be totally oblivious to the relationship between 0% interest rates and rampant speculation, but we all should know better by now. Their accommodative policies and the “Greenspan Put” helped inflate the internet bubble. Their solution to its eventual bust was the creation of a housing bubble. And their solution to the housing crash was apparently to create an all-encompassing reach for yield and risk bubble, this time under the guise of a “wealth effect.”

When this bubble eventually bursts, we can expect the Fed to do more of the same: deny any culpability and try to inflate once again. Market participants and bad actors will indeed be counting on the latter part as the moral hazard has been firmly engrained by now. The only question in my mind is whether the majority will once again stand for it all, especially as the wealth gap has only widened during quantitative easing and 0% interest rates. As Stanley Druckenmiller has said, quantitative easing has been the “biggest redistribution of wealth from the middle class and the poor to the rich ever.” Indeed, households in the top 20 percent of U.S. socioeconomic groups saw their incomes grow by an average of $8,358 a year from 2008 to 2012, compared with a $275 annual decline for the lowest 20 percent, according to data from the Bureau of Labor Statistics.

Can this really be good long-term policy? And does a policy focused on the creation of bubbles and crashes really promote the Fed’s “dual mandate” of maximum employment and stable prices? I think we all know the answer to these questions but as we’re mesmerized by rising asset prices, we remain silent. Only after a sharp decline will we start pointing fingers, but again, most will be looking for the Fed to do more, not less at that point. With the end of QE coming at the end of October, the debate may come sooner than most think.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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