Fed's Famous Last Words: Uncertainty, New World Order, and the Quest Ahead!
Abraham George Macro Musings
Alan Greenspan assumed the role of Federal Reserve Chairman on August 11, 1987. Shortly after taking office in October of that year, the US stock markets experienced their largest single-day crash. While it would be unfair to attribute the 1987 crash solely to Greenspan, it is worth noting that by the end of that year, the NASDAQ Index was valued at around 486.
On December 5, 1996, Greenspan delivered his now-famous speech at the American Enterprise Institute, in which he highlighted the presence of "irrational exuberance" in the stock market. At the time of his speech, the NASDAQ stood at 1392. Over the course of the following nine years, stock prices tripled, representing a compounded annual growth rate of 12 percent. While this achievement was remarkable, it was also unlikely to be sustainable in the long term.
To Greenspan's chagrin, the market continued to soar for another three years. By the end of 1999, the inflation-adjusted Nasdaq index reached a staggering 4106—three times higher than when Greenspan had issued his warning. This turn of events appeared quite unfavorable for Greenspan.
Fast forward to March 2007, when Ben Bernanke, serving as Fed Chairman, emphatically assured a congressional hearing that the subprime mortgage crisis was contained. We all know what transpired after that statement. Let us move forward. On June 27, 2017, Fed Chairwoman Janet Yellen declared that she did not anticipate any new financial crises in our lifetimes.
Now, we find ourselves under the leadership of another Fed Chairman who attempted to persuade us that the rise in inflation would be transitory. Yet, in just over a year, interest rates were raised ten times, marking the fastest pace of rate hikes since the Fed's establishment.
The aforementioned instances represent the famous last words of four different chairpersons who were subsequently forced to confront the consequences of their statements. Despite having access to vast amounts of information and the analysis of numerous experts, the truth is that the Federal Reserve does not possess any greater certainty than you or I.
Allow me to clarify further. The Federal Reserve's game revolves around confidence and trust. Even when faced with dire situations, they are compelled to deceive or find ways to postpone the inevitable. The can has been kicked so many times that it has become flattened, losing its momentum with each subsequent kick. Unfortunately, they can never exclaim, "Houston, we have a problem." They inadvertently ignite the fire and are subsequently left with no choice but to extinguish it themselves.
The question remains: How much longer can this continue? There is no doubt that we have reached a breaking point, requiring the establishment of a new world order. I have alluded to this idea in my previous writings, but I must admit that I am uncertain about how events will unfold. However, I will delve into my calculated assumptions regarding the new game in my future works. Stay tuned.
Perhaps the most significant lesson the Federal Reserve has learned and implemented since the Global Financial Crisis (GFC) is the importance of swift action when a crisis erupts. They do whatever it takes to contain the fire. This was evident when overnight rates surged dramatically on September 17, 2019, as well as in their rapid response to the fallout from COVID-19 and recent bank failures.
What many people are unaware of is that the dollar amount associated with the three bank failures surpasses the total of 25 failed banks during the GFC. Admittedly, the economy is much larger now than during the GFC, but thanks to the government's swift actions to prevent a contagion, the market has yet to feel the impact significantly. However, everything comes with a cost, and how this will ultimately play out remains the multi-million-dollar question.
All of the recent bank failures can be attributed to a common cause. These banks held a substantial number of long-dated securities that had experienced declines in value due to the Federal Reserve's record-setting aggressive monetary policy. As depositors withdrew capital from these banks, a severe liquidity crisis ensued.
Among these banks, First Republic was the largest. Authorities made various attempts to salvage it, but regulators scrambled to find a buyer, unwilling to shoulder the burden themselves. After much deliberation, discussions, and a violation of several written policies, the bank was ultimately bundled up and handed over to JP Morgan.
What proved surprising was Warren Buffett's lack of interest in this opportunity. During the GFC, when Goldman Sachs was on the verge of collapse, Buffett stepped in to save it with a $5 billion investment, in addition to acquiring inexpensive warrants that allowed him to purchase another $5 billion worth of Goldman Sachs stock. This deal resulted in billions of dollars in profits for Berkshire Hathaway. Many expected Buffett to similarly intervene in the case of First Republic. However, with concerns, particularly from Munger, about the worsening situation in commercial real estate, Berkshire deemed the risk-to-reward ratio unfavorable.
Nevertheless, the authorities' decision to prevent a complete collapse and compel other banks to follow suit was a commendable move. It was, without a doubt, a clever move by JPMorgan, although it did come with its fair share of challenges. Under normal circumstances, such a deal would not have gained approval from the Federal Trade Commission (FTC). However, due to the emergency nature of the situation, rules were bent.
What is truly astonishing is that all of this has had minimal impact on the markets. Personally, I believe the last two Federal Reserve rate hikes were probably unnecessary, and by adhering too strictly to the zero-interest-rate policy for an extended period, they have tightened monetary policy excessively for this cycle.
In my strong belief, the tightening cycle has come to an end. The significant spread between the Fed funds rate and the two-year yield clearly supports this assertion, with the spread being around 120 points lower. In the past year and a half, inflation and the Fed's response have dealt a heavy blow to the stock markets, resulting in wild volatility. Despite these challenges, the markets are still trading above the descending trendline and the 200-day moving average. The next significant hurdle for the S&P 500 stands at 4200. Overall market sentiment appears bearish, with the market leaning towards a short position. These indicators bode well for a market rally.
The first-quarter earnings reports brought several positive surprises. More than 85% of companies that have reported earnings thus far have beaten estimates, representing approximately 80% of all companies.
However, there is an obstacle hindering further market progress: the ongoing gridlock surrounding discussions on the debt ceiling. Both sides of the political spectrum harbor deep animosity and mistrust towards each other. Ironically, the party in power tends to be loose with their finances, while the non-ruling party suddenly rediscovers fiscal discipline. As history has shown, last-minute solutions tend to materialize, but there is still a possibility—a black swan event—that no default is fully accounted for. Bad things often transpire when least expected.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office, and a hedge fund.