"Don't Fight the Fed?"       June  2001 - Issue 10

"Don't fight the Fed" has been the mantra trotted out by the investment community during the first half of 2001. This, based on the notion that US monetary growth and aggressive interest rate cuts will ultimately engender the hoped for 'V shaped' recovery desperately sought to sustain current stock market valuations. Historically, during a typical economic cycle this may well have worked, but alas not after an asset bubble such as witnessed in the US of late.
  
Very high economic growth, mostly financed by excessive money supply is usually followed by an extreme misallocation of capital, leading to a decline in corporate profits and a subsequent decline in both equity and corporate bond quality. This leads to a reduced economic activity, which in turn triggers another decline in both the stock market and interest rates i.e. a classical liquidity trap!

The top chart above shows a close similarity between US and Japanese interest rates (adjusted for a time lag of 10 years). In the late 1980's Japan, a mis-allocation of capital ended up in the property market, whilst in the late 1990's US, the recipient were initially the Internet and Telecommunication sectors. Not content with the results of a stock market bubble pumped up by an unprecedented money creation, the US Fed under the captaincy of Uncle Al has continued to throw petrol onto the fire, running the money supply at over 13% annualised since the beginning of the year, partially transferring the bubble to the real estate markets.

Any hoped for benefits from the interest rate cuts are being eroded by the sheer burden of debt built up over the past five years, by both corporate and private individuals. The consequent inability to service that debt is becoming apparent and will get worse.

We note the interest rate profile between the 1920-45 period and 1990 to date (RH chart)for the US. Market historians will recall the mania of the 1920's, assisted by a ballooning of the money supply, which was followed by the depression of the 1930's. The expansion of credit during the 1920's exceeded that of the stock of money by a large amount. But it does not compare with the credit explosion since 1995. While GDP expanded annually by some $500 billion, the volume of new credits swelled by $1.4 Tr in 1997; $2.1 Tr in '98 and by $2.25 Tr in 1999. Latter day Japan is certainly instructive. The unwinding of the excesses has persisted for a long time and proved impervious to repeated interest rate cuts. Japan has had years of virtually zero interest rates and during the past few weeks we have witnessed the unprecedented spectacle of the Bank of Japan injecting hundreds of millions of Yen into the banking system only to see the nations banks refuse to accept these virtually free funds.

In a world of free capital movements, the consequences today will be huge. How many investors will be willing to invest (or continue to invest) in the dollar at zero interest rates, if the Fed has to go that low? Recent evidence suggests that a large chunk of this year's money growth expansion has been the result of foreign purchases of US stocks and bonds. US domestic agents have been selling these securities and moving into cash. Effectively, the foreigner has accommodated the US selling and had this not happened there might well have been a major financial crash in the US economy. We are reminded of a child's party game of 'pass the parcel' or 'musical chairs' and finish with a suggestion "Do not be left with the parcel as the music stops!"