The Outcome of the Fed’s Interest Rate Cuts? History is the Best Oracle.

January 28, 2008 –

The most accurate oracle regarding the effects of the rapid U.S. Federal Reserve interest rate cuts is history. The Feds have taken this path before and the results have never been pretty. Not one single time. Though the sentiment on the street seems to be that the Feds may not be inclined to cut interest rates significantly in a couple of days given their emergency rate cut of 0.75% a week ago and the revelation that Societe Generale exacerbated the plunge of European stock markets by recently closing out all open positions maintained by rogue trader Jerome Kerviel. Still, given the Fed’s foolish reactions to every economic problem in recent history, I would not be surprised if they caved to Wall Street interests and cut interest rates by another .50% in a couple of days. However, even if they only cut interest rates by 0.25%, this would still produce a cumulative 200 basis point reduction in the Fed Funds rate in just the past four months. Those are huge rate cuts no matter how you slice it. But no matter the “dead cat bounce” that the Feds are attempting to manufacture right now to provide stability to the markets, their plan will ultimately fail. History tells us so.

Historically Comparable Scenario to today: 2000-2007 U.S Economic Timeline – Dot com crash, U.S. Federal Reserve manufactured real estate bull, subprime mortgage fallout….Next? Real estate bear and depression??

The dot com bubble collapse caused the U.S. NASDAQ index to plummet from a peak of 5,038 in March, 2000 to 1,114 in October, 2002— a decline of 78% in less than three years. Runaway valuations and frenzied buying of a hot sector caused the tech market to collapse as investors and venture capitalists threw money at tech companies, inflating the value of companies that had never declared a single dollar in revenue or profit. Even though revenues, earnings and cash flow were all absent, this didn’t seem to make a difference as a rapidly rising index provided a rising tide that lifted all boats regardless of the missing components of quality or fundamental soundness.

When the unsustainable tech bubble burst, and in the process dragged the S&P down with it, to ease the pain of losses in the stock market, the U.S. Federal Reserve cut the Fed Funds interest rates a dozen times from 6.5% to 1.25% (the discount rate was cut 13 times to 0.75%). Sound familiar? This spurred massive speculation in the housing market. These massive interest rate cuts achieved two simultaneous goals. The upside? (1) They pulled the U.S. economy quickly out of a deep recessionary environment; and (2) Fueled massive equity gains in the housing and RE market that allowed many Americans to forget the pain they had just suffered in the stock markets.

The downside? The deep interest rate cuts directly created the sub-prime crisis that reared its ugly head in 2007. As buyers jumped into the U.S. real estate market to buy houses beyond their budget, courtesy of the U.S. Federal Reserve “nearly free money” policy, rampant speculation in the real estate market created an unsustainable rise in real estate prices. In 2007, this lax fiscal policy came home to roost as a period of increasing interest rates caused defaults on low-quality, high-risk subprime mortgages. In turn, these defaults created a global liquidity crunch that may soon evolve into an insolvency crunch.

So why can’t the Feds replicate this same recovery this time around? Why can’t they save the economy now and manufacture an ENORMOUS problem that we’ll have to face down the road, just as they have in the past? The answer is this. When we look at today’s economy, it is indeed in much more dire condition than the one we had to stimulate back in 2000-2003. Back then, the U.S. Federal Reserve was only on the path to printing the dollar into oblivion, but the dollar wasn’t at the tipping point. With the dollar now at the tipping point, taking such an approach and lowering the Fed Funds interest rate to 1.25% would surely push the dollar over the cliff. Furthermore, back then, the U.S. was able to, with its free money policy, still stimulate much of the domestic economic growth from within. Currently, much of the domestic economic growth is coming from the outside. According to the Bureau of Economic Analysis, a division of the U.S. Department of Commerce, foreign private holdings of U.S. securities increased 20% from 2005 to 2006 and constituted an estimated whopping 30% to 35% of the entire U.S. stock market cap of approximately $15 trillion. With the dollar steadily depreciating against all major currencies and almost all emerging currencies in 2007, I would not be surprised if foreign ownership of the U.S. markets stood at 40% to 50% today.

Why is this important? During the course of my job, I travel a lot. To Korea, Indonesia, Thailand, China, the United States, and most likely the Middle East this year. The spin doctors are working overtime now in the United States. That’s why we had Goldman Sachs spin the story that shorting gold was one of its “top 10 trades for 2008” in November of last year. Gold was trading at $794 when they made that announcement. Today gold is trading at over $928 an ounce, not even two months after they told the world to sell gold and the world foolishly listened, pushing down gold prices almost immediately (but of course only temporarily). What a “top 10 trade” that turned out to be. This week, in the State of the Union address, President Bush stated: “In the long run, Americans can be confident about our economic growth.” Spin, spin, spin. The problem with this spin is that the rest of the world doesn’t receive the same spin that we as Americans do in our homeland. I know because I watch the news and read the papers in the different countries I visit. When Bush stated “Americans can be confident about our economic growth”, given the insane foreign ownership of our stock markets, it’s not Americans who need to be confident of our economic growth, it’s foreigners that need to be confident of this. And God help our stock markets, if they lose this confidence.

So what happens when foreigners aren’t bombarded by our spin doctors favorite Bob Marley response to dire economic outlooks: “Don’t worry about a thing, ‘cuz every little thing is gonna be alright.” What happens if foreigners that are presented a much different picture of our economy starts to lose faith in our economy, and more important yet, what happens when they give up on the U.S. dollar? Do you really think that they will want to keep holding stocks denominated in dollars? For a while, devaluing the dollar against other major countries by 50%, 60% and 70% over the last 5-10 years has worked. This is evident by the amount of foreign capital that has poured into U.S. markets that have become ridiculously cheap for foreigners in recent years. But for the U.S. Federal Reserve to insist on playing this very dangerous game, you know what the saying is when you play with fire. Eventually you’re going to get burned. And given the course we are on now, this gold bull run is undoubtedly set to enter really sunny days.

[tags]dollar crisis, U.S. Federal Reserve, gold, global economic recession[/tags]

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