Alan's SecretsAlan's Secrets
| What you see with central bank policy is not always what you get. The Fed's reluctance to disclose its policy initiatives in the early 1990s is a good example. If Alan Greenspan had talked openly about the technical bankruptcy of the US banking system, it is possible that the loss of confidence would have prevented the rescue operation. In mid-1997, Mr. Greenspan again faces a difficult conundrum. Domestic inflation pressures by some measures are rising, which argues for higher short term interest rates. However recent financial bankrupticies in Japan are troubling, a problem which would be worsened if higher US interest rates lead to declining stock and bond markets. Since he will always have superior information, we can gain insight by watching how he responds in balancing his differing objectives. Reluctance to raise rates more than token amounts when faced with inflationary provocation would be indicative of his secret concerns. |
Central bankers have many objectives in their conduct of monetary policy. Textbooks generally cite five: price stability, currency stability, oversight on the banking system, fostering "appropriate" economic growth and managing the government's debt. Unfortunately, they have only two weapons (both crude) at their disposal. The two weapons available to central bankers are control of very short term interest rates, and regulation of the required reserve positions on various forms of deposits, a weapon which has become virtually useless in recent years.
Having five targets with only one main weapon often places central bankers in an awkward situation, since they must change primary targets as circumstances change -- and there is no assurance that each target requires the same interest rate action. They have therefore made frequent use of exhortation or "moral suasion" in an effort to accomplish their secondary objectives.
Fundamentally, central bankers are interested in the flow of liquidity through the capital markets, but liquidity in financial markets is a difficult factor to analyse. It needs two coincident developments to flourish: monetary stimulation provided by central bankers to their banking system, and then the joint confidence of bankers and investors to lend and borrow with the hope of creating wealth.
The speculative analysis which follows is predicated on the belief that central bankers may at times resort to disinformation or misdirection to accomplish their goals, or less strongly, there will be times when they will not feel able to be fully candid with the markets. Therefore, in our role as investment manager, we cannot rely solely on the words of central bankers to fully understand their objectives for the financial markets. We must analyze their actions in relation to coincident events to infer whether the "central banker-speak" conveys their whole truth.
In October 1990, the US banking system was in crisis. Bad loans and bad interest rate judgements had rendered many components of the system technically insolvent. The share price of Citicorp, a fair proxy for imprudent banking at the time, fell from $35 in October 1989 to $11 one year later. From the turn of the year to the crisis point, Chase Manhattan fell from $30 to $10, Merrill Lynch from $13 to $8, and even JPMorgan, the epitome of prudence fell from $44 to $30.
Short of investing directly in a failing bank, lowering the bank's cost of deposits is the sole method available to a central bank to sustain a bank that is "too big to fail."This blunt mechanism has two effects, both very beneficial for financial institutions. Lowering borrowing costs is slow to take effect, since if a bank pays its depositors 6.5% and charges its borrowers 9%, the bank makes 2.5% profit over a year. Not bad. But if a bank borrows money at 6.5% in the short term markets which are under central bank control, invests the proceeds in the bond market, and long term interest rates then fall creating capital gains, the effect is dramatic and immediate.
The Federal Reserve reacted in dramatic fashion, shifting its attention to the banking crisis, the most urgent problem of the day. Between the end of October and January 1991, they dropped their Federal Funds rate from 8.25% to 6.5%. For those banks without major loan problems, this flood of low cost liquidity brought fabulous profits. By the end of 1992, the share prices of JPMorgan and Chase had more than doubled from the crisis low, while shareholders of Merrill Lynch were four times wealthier. Citicorp's problems proved more intractable, and shareholders despaired as the stock price bottomed at Christmas in 1991 The Federal Reserve continued to press their funds rate down until the end of 1992, until it stabilized at 3%. Confidence in bonds escalated rapidly, and the engines of liquidity worked overtime.
In 1992 and 1993 combined, the long term bond market provided capital gains of close to 20%. The "carry trade", as this mechanism had come to be called, was so profitable that many others, particularly hedge funds, rushed to enjoy the ride, borrowing at a low cost and buying bonds. As the potential gains became obvious, unsophisticated investors joined in, pushing the bond market up dramatically in rampant speculation. By the fall of 1993, the recapitalization of the banking system was complete. Even Citicorp had by then increased to $22. At no time during this process did the Federal Reserve acknowledge the magnitude of the problems.
The solution to the banking problem engendered another serious concern for Mr. Greenspan. The liquidity needed to keep Citicorp et. al. afloat provided the fuel for the speculative fires in the bond market, stimulating economic activity and raising the dreaded spectre of domestic inflation. In early 1994, Mr. Greenspan raised short term interest rates "preemptively" to slow the economy and dampen the trend to higher prices. This initiated a sequence of events that he probably did not fully anticipate. The "carry trade" positions had to be unwound as short rates moved up, and bond prices weakened. As prices fell, more speculators were forced to sell in a vicious cycle. By the end of the year, bond prices had fallen as much as 25%, Orange County was bankrupt, hedge funds were in disrepute, and many bond investors were severely damaged.
This rise in rates exacerbated a very difficult situation in Mexico. Servicing Mexico's external debt and financing their current account deficit with higher interest rates brought a crisis in the peso (which collapsed by 50%), austerity, and the threat of social collapse along the US southern border. Faced with the threat of unacceptable chaos in a major trading partner and desperate problems with illegal immigrants, the US Treasury loaned Mexico $50 billion and the Federal Reserve announced that it was prepared to act as the lender of last resort to Mexican banks. Liquidity began to flow again. The Federal Reserve dropped the Funds rate from 6% to 5.5% immediately, and basked in the glow of an apparently successful stabilization effort. This operation added a sixth responsibility to the already overburdened Fed.
There was not much time to rest. In the spring, the depression in Japan intensified as the Bank of Japan finally abandoned the attempt to hold the Yen at 100 per US dollar. The Yen rose under intense speculative pressures as high as 80 per US dollar, at which point virtually no Japanese exporter could remain in business. The situation was truly desperate, and the governments of the major countries, including their central bankers, acted in unison to change the trend. There were two related objectives: initiate an advance in the sliding Japanese economy, and save the Japanese banks which had wasted all of their capital in the real estate mania of the late 1980s.
The central bankers modelled their efforts after the successful recapitalization of the US banking system. The Bank of Japan dropped short rates to 50 basis points while US rates were held up, giving Japanese banks the opportunity to borrow short term in Yen at very low cost, invest longer term in dollar bonds, thus picking up the spread, and realizing capital gains on the currency appreciation as the yen fell. Continental European central banks also opened their monetary spigots to full flood. Liquidity, because of the important role that confidence plays in its creation, readily leapt national boundaries. During the US recapitalization effort, skillful speculators used the opportunity to profit from the rising bond market. (The unskilled got caught!)
During this second recapitalization, the liquidity spillover flooded the world stock markets. Investors remembered the pain of declining bond prices, but developed astonishing confidence in the stock markets. The acceleration of the S&P 500 began in early 1995, at precisely the time when the Federal Reserve accepted the role of Central Banker to the world.
By late 1996, evidence had accumulated which hinted that Japanese economic resurgence was at hand. It should have been - the degree of stimulation applied to the Japanese economy far exceeded Keynes' wildest imaginings. This allowed Mr. Greenspan the freedom to once again consider his own domestic situation, and he was disturbed. In December, he reflected publicly on the "irrational exhuberance" of the stock market (Is this a seventh role?), and subsequently highlighted tightness in domestic labour markets as posing an inflation threat. On March 25th, Alan Greenspan raised short term interest rates as another "pre-emptive strike against potential inflation."
As long as there is relative tranquillity on the other fronts that remain in his purvue, he will be able to retain this focus. Unfortunately, the evidence of the past six years is that other concerns rapidly emerge that demand his complete attention, and now that the list of targets has been expanded to seven, the odds of rapid change are higher. Two days after the pre-emptive strike in March, an event that ought not to have happened if the Japanese banking system recapitalization was complete did happen. The Ministry of Finance announced a restructuring plan for Nippon Credit Bank (a mid-sized Japanese lender to now-bankrupt real estate firms). In April, the Nissan Life Company (16th largest) was placed in receivership. If the Bank of Japan and Mr. Greenspan know whether this is part of a healthy cleansing process, or symptomatic of a banking system that is only now starting to acknowledge problems created during the bubble economy of the late 1980s, they will not tell us.
Our job as investment managers is to infer as best we can what is now running through Alan's mind. It seems that he is reluctant to raise rates. Does he remember the unwinding of the bond speculation in 1994, and the bankruptcies of imprudent speculators like Orange County? Does he fear that speculation in stocks might unwind similarly? Will liquidity, created as it is by investor confidence, be a coward, and run from financial markets? These are Alan's secrets.
Article
by Bob Swan - May 5, 1997
Investment Strategy
Monetary Policy
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