Forcing the Fed’s Hand
Adam Hamilton
October 11, 2002
 

The private central bank of the United States, the so-called Federal Reserve, is always a contentious subject to discuss.  Just like the ancient Islamic jihad against the Jews, abortion, or any controversial issue, strong feelings exist on all sides regarding the Fed.
 
Some people, usually government bureaucrat and politician types, think the Fed is a great thing. They still believe Keynes’ hollow promises that the free markets can be bent at will by secretive private bankers pulling on tiny levers behind a curtain.  They generally trust government far more than they trust the free markets and the Fed’s manipulative work is right up their alley.
 
Standing in opposition, there are folks like me who deeply love freedom and free markets.  We believe the Fed is an unconstitutional abomination, foisted upon the unsuspecting American people by stealth and subterfuge in 1913.  It never ceases to amaze me how few investors and speculators seem to be bothered by the rank hypocrisy of the institution of the Fed, which is neither federal nor a reserve, but a privately-owned central bank.
 
Like the old Communist Politburo central-planning committee in the Soviet Union, at the Fed a group of unelected and unaccountable private bankers meet in secret in smoke-filled rooms like Mafiosos with the express intent of brazenly manipulating free markets.  They openly manipulate the price of money, interest rates, and few in the financial community even bat an eye at the whole hypocritical anti-free market nature of the exercise.
 
To put it into perspective, imagine if a group of unelected unaccountable men met in secrecy like criminals and arbitrarily decreed, like Middle Eastern despots, that every lunch in every city in America would henceforth cost exactly $25.  Whether you were eating a McDonald’s hamburger, a premium steak at a five-star restaurant, or tofu and salad (yuck), you would be forced to pay $25 because some Communist-like central-planners declared it should be so.  Preposterous, right?
 
Arbitrarily setting the price of lunch everywhere is obviously foolish.  There are different qualities of food, food experiences, and food has a different utility for different people at different times.  You might highly value sushi and be willing to pay $50 for a great sushi feast.  Me?  I wouldn’t touch that stuff at any price even if I was starving to death out in some God-forsaken desert!  Just like food, money has different utilities for different people at different times too.
 
If you are founding a new company you are probably willing to pay more for the privilege of borrowing money from hard-working savers.  If you live in a boomtown, like Silicon Valley’s San Jose of a few years ago, you are probably also willing to pay more for money.  On the other hand, if you simply want to buy a house for your family in the American Midwest, you probably won’t be willing to pay high interest rates for the privilege of debt-financing your dwelling.  The prices of money, interest rates, are no more one-size-fits-all commodities than lunch!
 
It absolutely flabbergasts me that more investors and speculators today, at the enlightened dawn of the glorious Information Age, don’t question the dubious wisdom of having mere mortals just like us meet in secret at the Fed to manipulate the price of money.  While I can certainly understand why control-freak politicians, spineless bureaucrats, and Keynesian big-government evangelists and apologists like the idea of the open manipulation of interest rates, it is astonishing that more people actually running capital in the real world are not up in arms at the whole anti-free market travesty.
 
Arbitrarily setting any price in free markets by official decree is outrageous and irrational!
 
Anyway, lest I digress much farther, I am not writing this essay to attack the goofy premise of the Federal Reserve specifically.  I will save these thoughts for future essays.  As an active investor and speculator, regardless of how abominable I believe the Fed’s market manipulations are, I recognize that it is a force we unfortunately have to reckon with if we are involved in the markets today.
 
Short-term market movements are dominated by human emotions, greed and fear.  The Fed’s manipulations of the price of money often have the potential to kindle existing greed to raging intensities or petrify existing fear to chilling depths.  As such, any short-term speculator absolutely has to monitor the Machiavellian anti-free market machinations of the Federal Reserve.
 
In addition to more traditional technical tools like volatility, ratios, and sentiment indicators, speculators must keep one wary eye on the Keynesian central-planners manning the helm at the Fed.  There is probably no other single entity on Earth that can radically alter general greed and fear levels as rapidly as the Fed.  If you have any doubts, please check out the first graph of my essay “The Greenspan Gambit” I penned way back in early 2001 a few days after the Fed’s first rate cut, explaining the ultimate long-term futility of such intrigues during a supercycle bubble bust.
 
Late last week, a surprise announcement appeared on the Fed’s official website with little fanfare.  The “Advance Notice of a Portion of a Meeting under Expedited Procedures” declared that an emergency Fed meeting was to be held on Monday October 7th.  The only single “Matters to be Considered” was the following…  “Review and determination by the Board of Governors of the rates of discount to be charged by the Federal Reserve Banks.”
 
If this typical Fed-speak bureaucratize gobbledygook hasn’t euthanized your brain yet, please allow me to translate.  “We at the Fed are utterly terrified at the collapsing US equity markets so we are throwing a last-ditch hootenanny to decide if we should slash interest rates yet again to reignite greed in the speculating American populace.”
 
This surprise meeting notice, along with an intriguing inversion in the short-end of the US “risk-free” government debt yield curve led us to take a look at Fed actions in recent history to see if we could learn anything about the modus operandi of the central planners in slashing interest rates to goose flagging equity markets.
 
Normally, and intuitively, the longer the term for which a debtor wants to borrow money, the higher the interest rate charged.  If you want to borrow lunch money for one hour until you can hit an ATM, the risks of something unexpected happening in such a short time are vastly lower than if you want to borrow money for 30 years to buy a house.  Similarly, it should cost more for the US government to borrow money for 2 years, in which lots of unexpected events can transpire, than for a bank to borrow money overnight.
 
Most of the time the overnight fed funds rate is lower than the yield on 2-Year United States Treasury Notes.  It is just much riskier for savers to lend money for 2 years than for a single night.  We can be fairly sure tomorrow morning will look at a lot like today, but what about 2 whole years from now? 
 
Where will the markets be?  Where will interest rates be?  Will the US still be willy-nilly invading third-world countries and starting wars for no cause?  Will Washington, DC be a glowing radioactive crater when the Third World inevitably decides to fight back against US neo-imperialism?
 
We can be 99.9% certain on these answers 24 hours from now, but not 17,532 hours from now (2 years).  In addition to vastly more uncertainty, 2 years exposes savers’ scarce capital to the ravages of inflation for a much longer period of time.  If you are intellectually honest and diligently study the history of the abominable Fed since 1913, the sole conclusion you will reach is that the only thing the Fed has accomplished is to utterly destroy the value of the US dollar through relentless inflation.
 
As long as the Fed hangs around the necks of the American people like a bloated, diseased, dead, stinking albatross, we can rest assured that our dollars will be worth less 2 years from now than tomorrow.  Overnight interest rates should, without a doubt, be lower than 2-year interest rates.  Because of an anomaly today, this is no longer the case.
 
 
Normally positive, the spread between 2y T-Notes and the overnight fed funds rate has plunged negative again.  While rare in longer-term history, it is very disturbing that this has already happened twice in the short six year timespan shown above.  Both the frightening 1998 Long-Term Capital Management hedge-fund implosion and the horrific 2000 NASDAQ bubble burst have pushed this normally positive yield spread inverted.
 
Why does this short yield spread invert?  The probable answer is simple.  Professional money managers moving the majority of capital today have been trained to exist in a fanciful binary universe.  They believe, with fervent zeal, that the only two worthy destinations for capital today are Stocks and Bonds.  What about real estate, gold, cash, futures, options, foreign stocks, and countless other investment and speculation destinations for capital?  If you work for Wall Street, you are effectively required to believe and act like they don’t even exist!
 
So if the equity markets are plunging in the worst supercycle equity bust in seven decades, and you are a professional money manager that has reached capitulation, you will dump your stocks and buy bonds.  This activity bids up bond prices, which of course drives down bond yields.
 
Even if you are a money manager or private investor and wish to go into “cash” today, cash as relatively safe bank savings accounts really don’t command much sway anymore in the investment world.  Today “cash” positions in mutual funds and brokerage accounts are often simply deployed in short-dated bond funds, also known as money-market funds.  In this environment, stock sales leading to “cash” provide capital that is instantly used to purchase short-dated bonds like the 2y Ts in the inverted yield spread.
 
Net net, when money flees stocks today it almost always, in one way or another, ends up flooding into bonds.  This mass influx of equity flight capital bids up bond prices and forces down bond yields.  (We recently published an essay on this phenomenon if you’d like to dig deeper, “Stocks and Long Rates”.)  Eventually, if the mass exodus from stocks is enormous enough, 2y yields plunge below the overnight fed funds rate and the Fed has a big mess on its hands.
 
As the red highlights in the graph above show, the Communist-style central planners at the Fed start sweating whenever the free-market 2y yield makes them look like nincompoops.  In both recent financial crises when this has happened, 1998 and 2001, the Fed inevitably bows to the superior force and fury of the free markets and rapidly hacks away at the overnight fed funds rate to catch up with the plunging 2y yields.  The red circles above mark these two episodes of panicky Fed action to catch up with free-market initiative at longer maturities of debt.
 
Provocatively, 2y Treasury yields are now drifting below the fed funds rate again today.  The cartel of private bankers at the Fed has zealously held the 0% line on the spread since mid-2001 and it will be exceedingly interesting to see what happens in coming weeks.  The lower the 2y-FF spread heads, the higher the probability the Fed will panic yet again and slash overnight rates farther even from these low levels.
 
Our next graph uses the same short spread above and compares it to the flagship US S&P 500 equity index.  Superimposed on the graph are arrows representing every Fed rate cut covered in this time horizon.  White arrows represent rate cuts happening at normally scheduled Federal Reserve meetings.  Red arrows represent moments when the Fed panicked and figured it couldn’t afford to wait even a few weeks before its next scheduled meeting to make the rate cut.
 
 
Holy mixed messages Batman!  The Fed has long claimed that it was some ivory tower fortress tasked with ignoring the equity markets and focusing solely on manipulating the price of money for the real US economy.  The distribution of the Fed’s recent rate cuts on this graph should undeniably shatter this Fed propaganda myth, one of many.
 
There have been four emergency inter-meeting rate cuts since 1997.  100% of them have occurred at times of extreme market weakness.  The equity markets plummeted, capital fled to bonds, the 2y yield plunged as fresh money flooded in, and the Fed’s hand was forced.  Rather than suffer the embarrassment of an inverted short yield curve, which exposes the utter foolishness of the market manipulations at the Fed for the whole world to see, the Fed refused to wait only a few weeks and hit the panic button to cut rates between meetings.
 
Only the most recent emergency rate cut occurred when the 2y-FF spread was not deeply negative.  This cut, however, had extraneous circumstances that explain its advent.  On September 17th, 2001, the day the US markets opened after the Twin Towers collapsed on live television, the Fed announced an emergency 50 basis-point cut right before trading began.  Interestingly this was not only a reaction to a potential stock market panic, but to record-low 2y yields at the time following the days after the attacks.
 
Zooming in we can gain a superior perspective on the interest-rate market-manipulation schemes of the Fed during the bust alone.

Other than the post-9/11 Fed panic inter-meeting cut, the Fed has been remarkably consistent in when it launches its short-rate manipulations.  It seems to prefer to make emergency inter-meeting rate cuts only when a few powerful market forces converge in harmony.
 
First, the short yield spread has been inverted.  This is inevitably a direct response to the second factor, that flight capital has been hemorrhaging out of stocks and deluging into bonds at immense speeds.  The liquidation of equities spawns sharp drops in US equity prices, evident in the S&P 500 above.  The Fed seems to like to wait until after it thinks an oversold fear-driven bounce has started before it pulls Keynes’ levers and manipulates the price Americans must pay for money.  This same pattern occurred back in 1998 as well, as the previous graph shows.
 
It is really provocative that these emergency rate cuts always seem to occur after an apparent short-term market bottom.  We believe it is strong evidence that the Fed carefully monitors crucial US stock market technical levels like a hawk.  Since attempting to actively manipulate the free markets is tough business that can easily backfire, the Fed seems to hold back its ammunition until it is relatively sure it is riding with the short-term uptrend before pulling the trigger. 
 
The secretive smoke-filled Fed backroom is full of mere mortals just like you and I who don’t like to be wrong any more than we do.  In order to minimize their probability of looking like fools, they seem to time their emergency inter-meeting rate cuts with oversold bear market rallies with remarkable technical precision.  This saves the central planners from the bowel-shaking earthquakes of doubt and remorse that would surely assail them if the markets continued plunging on the short-term bullish news of an emergency rate cut. 
 
Next time the Fed claims it is neutral on the stock markets, you will know it is lying through its yellow Keynesian fangs!
 
Another interesting development in the graph above is marked by the horizontal dashed-red line hovering at the 0% spread.  For whatever reason, it seems that since mid-2001 the Fed has been hellbent on not allowing the manipulated overnight fed funds rate to loiter above the free-market 2y Treasury yield.  Each time the spread has threatened to pierce 0% and dive to new depths like a bunker-busting bomb, the central planners have launched a preemptive rate cut. 
 
This development is important for speculators to consider because the spread is now once again hovering around zero, the level which has recently prompted rate cuts without fail.
 
While a 2y-FF spread plummeting below -1% seems to assure an emergency inter-meeting rate cut as it did in 1998 and 2001, the spread may not have to plunge this negative to spur another round of Fed market manipulations.  As the first graph above showed, the fed funds rate in 1998 when the emergency LTCM-induced rate cut occurred was at 5.5%.  As the new year of 2001 dawned, the fed funds rate was running 6.5%.
 
These high previous starting bases for Fed panics are important.  A 50bp (basis point, 1/100th of 1%) cut from 5.5% reduces short-term interest rates by an eleventh.  A 50bp cut from 6.5% reduces short-term interest rates by a thirteenth.  A 50bp cut today however, from an extremely artificially-low base of 1.75%, would lop off almost a third from overnight interest rates.  Proportionally, any Fed manipulations today will be much more powerful relative to overall overnight borrowing costs for banks as compared to the last two Fed panics.
 
This low base also suggests that the Fed can’t afford to wait for a full -1% spread this time around to act, as it would be far too large proportionally.  If they still want to aspire to play God over the free markets like arrogant fools, they may have to unleash their salvo much earlier before the short spread has a chance to plunge deeply negative.
 
The bottom line, regardless of what you personally think as a speculator about the anathema on America that is the Fed, is we all have to pay attention to its manipulative machinations.
 
When the Fed is officially announcing emergency meetings, when the US equity markets are extremely weak but already potentially bouncing, and when free-market 2y yields threaten to plunge below manipulated overnight interest rates, the probability of coming Fed rate cuts waxes large. 
 
If you are short-term long this is great news, but if you are still short you may wish to exercise extreme caution as any surprise Fed move is likely to accelerate a serious bear market rally.
 
The Fed’s hand may be forced.
 
Adam Hamilton, CPA