Bernanke’s Crash Course for Central Bankers: Save the Stock Market!

``The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”- Ludwig von Mises, Human Action

While US markets (Dow Jones and S&P up over 4%, Nasdaq 3.75% week on week) responded gleefully to US Federal Reserve Chairman Bernanke’s move to slash 125 basis points in the span of about 8 days, the global response had been uneven-most Asian markets remain under continued selling pressure while in Europe the reaction was mixed (Eastern Europe mostly down, Continental Europe up).

Could it be the bottom for US markets? Maybe. Maybe not. We are inclined to think not. See Figure 1.

Figure 1: Economagic: Rate cuts and the S & P 500

Some hail Mr. Bernanke’s move as being a “proactive” or “activist” Central Banker. We don’t share that view. Mr. Bernanke started his rate cuts following pressures in the credit markets which percolated into the stock markets, it was not an ex ante but an ex post response. Therefore, like typical bureaucrats he was reactive and employed treatment based solutions. The fact that he assertively slashed rates in an unprecedented scale makes him more of an aggressive reacting Central Banker than a proactive one.

Yet the $64 trillion question is “will the aggressive treatment based actuations serve enough to plug the impairments in the US banking system?”

If one looks at history for guidance we see that rate cuts do not automatically cause a stock market recovery especially if indeed the US is undergoing or nears a recession.

The most pronounced example is during the dot.com bust in 2000, despite the FED serial actions of pruning the Fed fund rates from 6% in 2001 to 1% in 2003 (green rightmost line), what transpired was a secular decline interspersed with short but powerful clearing rallies. At the end of the cycle, from the peak to the through, the S & P lost more than 40%.

This is not to suggest that history will repeat or even rhyme. It could or it may not. While we are leaning on the view that US could or is likely suffering from a recession today, we do not discount the possibility that it may even head off a recession. Until the underlying problem of malinvestments in the banking system gets to be resolved, US markets are likely to remain under selling pressure despite the current intense rally. A recession would expose the US markets to even more downside volatility.

But there is an important difference between the dot.com bust and the housing bust today, the recession in the US then was prompted for by capital spending excesses in the corporate sector, while today’s proximate trigger comes from the housing bubble bust which has spread over to a wider sector of the economy exacerbating the recession risks.

Moreover, we don’t share the mainstream view that curtailment of consumer spending is a prime reason why a recession could be triggered, as per John Hussman of Hussman Funds (highlight mine), ``recessions emerge not because of a general decline in the willingness to consume, but rather because a mismatch emerges between the mix of goods and services demanded in the economy, and the mix of goods and services that the economy has been supplying. Many industries experience continued growth during recessions (even if their stocks trade somewhat lower), while other industries experience profound demand shifts. In the late 1990's, there was clear overinvestment in telecom and information technology, and these sectors suffered disproportionately during the recession that followed. In the current cycle, the overexpansion has been in housing, debt origination, and leveraged finance, so a much different group of stocks will probably be hung out to dry this time.”

And because Chairman Bernanke believes that market actuations reflect the underlying economic conditions and its dislocations risks impacting the real economy, it has been a guiding economic principle for him to use aggressive monetary responses as revealed by his past speeches of the Financial Accelerator and Helicopter strategy. That is why we have been spot on in anticipating Bernanke’s policy approaches because he has been quite consistent with his views which have been translated into policy actions.

Lately we discovered in a past article (2000) that Mr. Bernanke even preached about rescuing the stock market as essential to protecting the economy. In an article entitled “A Crash Course for Central Bankers” published at the foreignpolicy.com he wrote to prove on the merits of subsidizing the stock market through aggressive policy responses (emphasize mine),

``Central bankers got it right in the United States in 1987 when they avoided deflationary pressures as well as serious trouble in the banking system. In the days immediately following the October 19th crash, Federal Reserve Chairman Alan Greenspan—in office a mere two months—focused his efforts on maintaining financial stability. For instance, he persuaded banks to extend credit to struggling brokerage houses, thus ensuring that the stock exchanges and futures markets would continue operating normally. (U.S. banks, which unlike their Japanese counterparts do not own stock, were never in any serious danger from the crash.) Subsequently, the Fed’s attention shifted from financial to macroeconomic stability, with the central bank cutting interest rates to offset any deflationary effects of declining stock prices. Reassured by policymakers’ determination to protect the economy, the markets calmed and economic growth resumed with barely a blip…

``History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.”

So given the accelerated activation of the Bernanke Put, it is of no surprise that like Pavlov’s dogs responding to a trained stimulus, investors ramped up on stocks, in the belief that the Fed’s implied subsidies as a guarantee for renewed risk taking. Talk about Moral Hazard.

One has to understand that policy actions such as interest rates adjustments operate on with a time lag, which means the impact is likely to be felt after a period of time and not immediately.

True, over the short run there are some benefits. The normalization of the yield curve (short term rates below long term rates) will help contribute to the banks profitability and possibly help rebuild its capital base. Mortgage borrowing costs will ease the burden for some borrowers as the reduced Fed rates affects the London Interbank Rates or LIBOR from which many mortgages are benchmarked. Home equity rates which are priced using prime rates follows the path of FED rates, are likely to also come down. Cost of funds for companies will similarly decline. A possible revival of “speculative spirits” on the backstop of expectations of a Bernanke Put or A FED subsidy. And negative real yields are likely to benefit stocks relative to competing assets as bonds, money market funds or certificate of deposits.

But it doesn’t bring back the heydays of loose borrowing standard. It won’t stop home prices from falling. It will punish savers where money market funds reached $3.3 trillion last week from $1.8 trillion in 2001 and where household deposits have reached $7.1 trillion during the third quarter of 2007 from $4.3 trillion in 2001. (Doug Noland). It will encourage further home equity extraction which will aggravate the highly indebted balance sheets of homeowners. It doesn’t take the risk away from bond insurers exposed to infected securities and from financial institutions loaded with leveraged debts.

Or said differently, FED action is actively working to defer on the day of reckoning or seems to be buying time in the hope that markets will self-heal without going through the required natural process of adjustments such as writing off losses, liquidating imbalances and recapitalization. The FED wants to recapitalize and leapfrog over other 2 processes.

Japan’s experience of market process denial- financing of companies with interlocking ownership, subsidizing of affiliated financial institutions and government forcing banks to make more loans to prop up insolvent institutions- resulted to a padding up of non-performing loans which magnified their imbalances that took over decade long to clean out.

MSN’s Jim Jubak has a good narrative on how failed policies caught up with Japan to essentially prolong the country’s economic agonies, from Mr. Jubak,

``Eventually, all this asset shuffling and all these accounting gimmicks couldn't hold off a final reckoning. Even a $70 billion bailout in 1999 wasn't enough to turn the tide. By 2000, a wave of 25,000 bankruptcies finally rippled through the Japanese economy.

``In the fiscal year that ended in March 2000, Tokyo's big banks sold $20 billion in stock from companies they had propped up, sending the Nikkei stock index down an additional 35% in the last nine months of 2000. That returned the stock market to the lows it had hit a decade ago.”

In short, while credit driven distortions could temporarily be patched up by the FED and the US government through present “reflationary activities”, odds for a massive unwind will continue to mount for as long as the market process to correct any mismatches in the mix of goods and services in the economy will be denied by procrastination.

After all has it not been the manipulation of interest rates that has been one of the major drivers of today’s US economic malaise?

As Professor Art Caden of Mises.org wrote (emphasis mine), ``incorrect interest rates create a tug-of-war between consumers, who now prefer present to future consumption, and investors, who are receiving the incorrect signal that consumers prefer future to present consumption. In the long run, this results in malinvestment as people attempt to undertake production plans that are inconsistent with the market interest rate; moreover, it reduces the net investment produced by the economy because people will only be able to invest the real resources available.”

So Bernanke’s advice to contemporary bankers-BUBBLE ON!