Bubbling Interest Rates

Adam Hamilton    January 26, 2001    3324 Words


When future economic historians study the United States equity markets of January 2001 and knock their heads together trying to assign a theme, they will not have any problems deciding.  The first trading month of the new millennium was sandwiched between two notable events, one a surprise and one that was not so surprising.  All month, the chatter on bubblevision, on the Net, and in the financial newspapers and magazines centered around a long sacred equity bull mantra…  INTEREST RATE CUTS!  (read aloud and add your own echo to emphasize the majesty of this fevered bullish chant)


On the second trading day of the new year, seemingly materializing out of the very luminous aether itself, the struggling US stock markets were rocked to their foundations by a surprise announcement.  The markets had fallen fairly dramatically in late December and on the first trading day in January, and the perma-bulls were beginning to sweat a little.  They had bravely stepped forward, placing their necks on the chopping block of history, and called bottom after bottom in the NASDAQ.  Unfortunately, since the highs in March, the NASDAQ easily slammed through all the widely heralded support levels like a screaming meteorite through a delicate spider web.  Each time the troops were “rallied” around to start buying, the fledgling advance would stall, nose over, and start spiraling towards the jagged rocks far below. 


On January 3, as folks were beginning to worry that maybe bubbles really did have consequences, Alan Greenspan donned his white cowboy hat and silver six-shooters, and threw the equity bulls a bone.  Riding up on his mighty white stallion, his FOMC posse in tow, the “Maestro” slashed interest rates by 50 basis points, touching off the biggest and most violent intraday rally in the history of NASDAQ.  This action in itself was very odd for a lot of reasons, which we articulated in our “Greenspan Gambit” essay published the week of the surprise inter-meeting interest rate cut.


Since that fateful day, the equity bulls have enjoyed a long and wild celebration.  They have exuded an aura of, “Surely, now that interest rates are falling, nothing else matters.  Fundamentals?!?  Baaah!  Who needs ‘em?  Markets always rally on interest rate cuts.”  All of a sudden, the former issues weighing on the markets, like the record US trade deficit, negative US consumer savings, massive public and private debt, the falling US dollar, plummeting corporate earnings, a probable recession dead ahead in the water, etc, fell like stray ducks on a skeet shooting range and were remembered no more.


For the contrarians, those few brave souls who are actually audacious enough to believe that archaic concepts like cashflow, valuation, and rate of return matter (the nerve!), January was a slap in the face.  It brought flashbacks of the speculative orgy of late 1999 and early 2000, where “investors” did not even care what a company did, as long as it had the fabled “dot com” in its name.  The pressure on the contrarians in January 2001 became so intense that even some long-time bears began calling for a substantial rally… not because the fundamentals were sound but just because “everyone else is doing it”, as in buying stocks.  Having absorbed innumerable market commentaries and prognostications in January, we are convinced that untold multitudes of contrarians and bears fell in utterly brutal attrition.  If February is like January, God forbid, and we extrapolate the trend, we expect that there will be less than a dozen contrarians left on the planet in March.


With the exception of the price of capital, nothing fundamental had changed one iota in early January.  Yet, the mantra of INTEREST RATE CUTS became utterly deafening.  Although nowhere near bored enough to try, we suspect that if you were to sample any random ten minute segment of bubblevision all throughout the month, that the probability would be 95%+ that the topic of discussion would be interest rate cuts. 


Interest rate cuts.  Interest rate cuts.  Interest rate cuts.  January was like being stuck in a nightmare with a broken record, or being tied down to a sacrificial altar and being forced to witness some bizarre equity bull initiation rite… truly scary stuff.


In order to find some refuge in sanity in the midst of a sea of speculative madness, we once again turned to the unparalleled wisdom of history to try and determine the ultimate results of interest rate cuts on famous historical bubbles.  In this essay, we examine the interest rate environments surrounding the two most famous bubbles of the 20th century, the famous 1929 debacle in the States and the equally notorious Japanese Nikkei implosion of 1989.  We were interested to see how well interest rate cuts helped slow or stop the normal process of unwinding speculative excesses that inevitably follow a serious equity bubble.  These historical episodes are useful to place the current NASDAQ rage in proper perspective.


Interest rates, of course, are simply the price of money.


Throughout this essay, we use the discount rate as the indicator of general interest rate levels and to plot the interventions of the central banks involved.  The discount rate is also known as the rediscount rate or bank rate, and it is the interest rate that a central bank charges commercial banks for borrowing money.  Originally, the discount rate was truly a discount, where no specific interest was charged but reserve funds were loaned to commercial banks and the repayment was at an amount higher than the original loan, representing an implicit interest rate similar to a zero-coupon bond.  Over time, however, the “discount” on loans from central banks eventually evolved into a true interest rate. 


Although other interest rate indicators, such as the federal funds rate, could also be used, we believe the discount rate is the best measure of market interest rate levels and central bank actions.  Commercial banks are usually the primary source of credit in an economy.  Although the huge “government sponsored entities” that repackage mortgages now rival commercial banks in raw credit creation, in general throughout history credit was controlled by the amount of money commercial banks could loan out.  Due to the incredibly inflationary practice of fractional reserve banking, increases in capital to the banking system through central bank borrowing can yield vast increases in the amount of credit available in an economy.  The discount rate is a measure of the cost of fresh borrowed central bank capital for these commercial banks, and is a great measure of the general price of new credit.  


We begin with the 1929 boom, bubble, burst, and bust that certainly needs no introduction.  The graph below shows the Dow Jones Industrial Average as the blue line tied to the scale on the right axis.  The blocked-in yellow columns show the discount rate, which is quantified on the left axis.  The data in this graph, and throughout the rest of this essay, is daily.  The interest rate environment during the 1929 bubble is very revealing…



The first observation that leaps out of this graph is the realization that interest rates WERE cut dramatically following the 1929 crash, and these moves by the teenaged US Federal Reserve did not do a bit of good!


Notice the series of discount rate hikes until the bubble popped, and then the frantic series of repeated interest rate cuts as the Fed tried to reinflate the bubble that just imploded.  Bubbles ARE fundamentally different, and the consequences are unavoidable.  Speculative manias are followed by deep busts of similar magnitude, where the speculative credit excesses created in the preceding bubble are slowly unwound.  The light green lines mark the general trend channel off the bottom, and note that TEN YEARS, yes TEN YEARS, after the bubble top that the DJIA was STILL trading at less than 40% of its bubble blow-off levels!


The Dow daily closing peak was 381.2 on September 3, 1929, and the index closed at 150.2 on December 30, 1939.  Ominously, the discount rate had been at the “we are giving away free money” price of 1.5% since August 24, 1937…  interest rate cuts did NOT make a material difference in this classical bubble bust!  Not shown on this graph, the DJIA finished 1940 at the ugly level of 131.1.


One recurring theme that jumps out in the DJIA in 1929, the Nikkei 225 in 1989, and the NASDAQ in 2000 is that the central banks begin RAISING interest rates immediately before the terminal blow-off stage of the bubble.  In 1929, the initial rate increase was executed on February 7, 1928, exactly 465 trading days before the ultimate top.  The DJIA closed, up on the session, to 196.85 on that day the campaign of desperate rate increases to slow down the out-of-control credit speculation was launched.


The central bankers, not being totally clueless or retarded but just “slow”, eventually realized that equity valuations were becoming extreme and attempted to raise the price of credit to stave off the dangerous speculative orgy that was accelerating all around them.  In all three graphs in this essay, this original discount rate tightening to attempt to short-circuit the rising bubble is marked by the gauge roaring into the red zone.


After the central bankers finally get off their duffs to try and slay the rapidly evolving monster, the equity valuations continue to rise faster and faster as the mania takes on a life of its own.  The central bank raises rates in rapid-fire succession to try and pop the bubble with magical silver bullets, before it gets out of control.


Of course, command and control NEVER works in a free market economy, and the elite central bankers are doomed to have as much success manipulating the price of money as would a Soviet Politburo member declaring a single national price for ANY commodity by regulatory fiat.  So, the bankers keep firing away at the speculative orgy with interest rate increases, but the stock market rockets higher and higher.


Eventually, for reasons that are never really adequately explained, raw greed melts into fear as savvy professionals sell out recognizing the futility of an exponential parabolic growth curve in an equity index.  The initial burst occurs, causing a massive decrease, between 25% to 40%, of the stock values seen at the bubble’s shaky summit.


At this stage in the game, the central bankers throw up their hands in despair because the bubble popped and they need to “save the markets”.  They begin to aggressively lower rates in the hopes of slowing the credit bubble bust.  This event is marked by the bomb on the graphs, because the bankers realize the markets are in deep trouble and headed into a major bust.  Never held accountable for the fact that the central banks were RESPONSIBLE for the original bubble in the first place due to their sloppy and relentless expansion of fiat currency, the bankers are heralded as heroes as they open the floodgates and try to deluge the developing bust with fresh credit.  Yet, ultimately, the bankers’ last-ditch effort to stop the natural speculative unwinding process proves futile.


The interest rate cuts are initially greeted with enthusiastic bear market rallies, and gullible folks are convinced that “all is well again”.  Wall Street uses the bear market rallies to suck in more naive investor capital.  During the rallies, massive amounts of spin and disinformation are put out explaining how “due to the interest rate cuts and fundamental improvements, the bear market is OVER”.  Many people throw their capital back into the insatiable jaws of the market, fully believing the hype.  They are led like lambs to their slaughter.  The consequences of a mania bubble are very real and irrevocable, and a bust ALWAYS follows a bubble.


The graph below shows the exact same pattern of central bank behavior regarding the discount rate and bubble valuations in Japan in 1989…



Hmmm…  Is it just us or is history trying to tell us something here?  Such as that bubbles have consequences, and “free money” interest rates are not a magical elixir that will transport a market to equity nirvana... 


The command and control elite central bankers in Japan sensed an impending credit bubble on May 31, 1989, throwing a vicious 75 basis point curve ball at the bubbly Nikkei.  The Nikkei 225 closed at 34267 that day.  Interestingly, in both the 1929 DJIA and the 1989 Nikkei, the silly equity markets actually RALLIED the day of the initial interest rate hikes!  Surely the perma-bulls must have put out a flak-storm of spin telling investors how the rate RISES were either “bullish” or “meaningless”.  Having just lived through NASDAQ 2000, all these historical lessons sure ring home and remind us of bubblevision propaganda last year in the States.


The Nikkei peaked on December 29, 1989 at 38916, exactly 149 trading days after the initial rate hike.  The Japanese central bankers, gotta love ‘em, even kept raising rates AFTER the bubble burst.  Rather than shooting the bubble with a few bullets, they threw the fire control selector switch to full automatic and emptied the whole clip into the shuddering beast!


Finally, on July 1, 1991, with the Nikkei 225 trading at 23291 (60% of the peak), the Japanese central bankers began the long progress of trying to reinflate their struggling equity markets with an initial 50 basis point interest rate cut.  It cut interest rates NINE more times over the next four years.  Eventually, on September 8, 1995, out of sheer desperation the discount rate was slammed down to a mere one half of one percent.  Even with virtually zero interest rates, the credit bubble could not be reinflated and the Nikkei traded sideways for a decade.  Today, eleven years after the bubble top, the poor Japanese stock market is still trading around 13700, a sobering 35% of its bubble top.


Greenspan and gang, are you guys paying attention?  Even if you go ahead and lower the discount rate to near zero, history says the bubble bust must be endured and will not be miraculously wished out of existence.


And that brings us to the sexy young market for today’s discriminating speculator, the National Association of Securities Dealers’ Automated Quotation system, commonly known by its less verbose acronym of NASDAQ.  Here is the graph, same conventions as the previous two… 



Before we get to the discount rates, the graph of the NASDAQ bubble never ceases to amuse.  The light green lines mark the general trend from January 1997 to late 1998.  Notice the discount rate cuts in late 1998.  That was when the rogue hedge fund Long Term Capital Management was imploding, and threatening to take the whole fragile derivatives world and international banking system down with it.  When Greenspan and his posse slashed interest rates here, they did not tell the world about LTCM… that seriously bad news oozed out later.  This is a good lesson for the perma-bulls who think Greenspan acted on January 3 just out of his deep love for sad NASDAQ speculators.  Chances are, as we discussed in the Greenspan Gambit essay, that something REALLY ugly below the surface sparked the emergency 50 basis point rate cut.  Just as he would not tell the markets what was really up in October 1998, he is similarly likely not disclosing to the markets the true reason for his actions now.


Notice the parabolic speculative blow-off of the NASDAQ which began in late 1999.  Please scroll back up and compare the trajectory of this anomalous maniacal frenzy to the DJIA 1929 and Japanese bubbles.  The NASDAQ is far worse!  It is steeper, bigger, and badder than our fine past bubble specimens!


No one will argue that the Dow in 1929 and the Nikkei in 1989 were not bubbles, yet still today most of the bulls will not bite the bullet and admit that NASDAQ 2000 was a bubble.  They will hem and haw and admit that there was an INTERNET bubble, but many refuse to acknowledge that NASDAQ itself was a bubble.  They probably steadfastly deny it because they KNOW that bubbles are followed by BUSTS, and they are terrified of the consequences of the biggest credit bubble in the history of humanity being slowly and painfully unwound.  It is indeed heavy and unpleasant stuff.


Greenspan and his cronies on the FOMC realized they had created a monster on August 25, 1999, when they raised the discount rate 25 basis points to “cool things off”.  Exactly 138 trading days and a couple rate hikes later, on March 10, 2000, the NASDAQ bubble summited at the lofty height of 5048.62.  The bulls jumped for joy, and assured the average investor that NASDAQ 6000 would be vanquished before the end of the year.  The long-heralded “new era” had finally arrived, with endless wealth and recurring spectacular annual returns for all.


Greenspan and the Fed, following the earlier example of our Japanese friends, kept raising rates even after the bubble burst.  Finally, on January 3, 2001, with the NASDAQ languishing at 2291, a mere 45% of its bubble peak, the Federal Reserve realized that the bust was real and dangerous (or more likely something ugly and huge was transpiring in the derivatives world and threatening the US banking system, like LTCM in 1998), and it made the extraordinary move of slashing interest rates by 50 basis points between meetings.  And the NASDAQ rallied violently and all the bulls got a warm and fuzzy feeling because the “Maestro” was on the case.


And in doing so, the Fed completely wrecked the flow of financial news in January, since all we ever hear these days is endless rhetoric about the magic of interest rate cuts.  An unfortunate side effect was many former outspoken contrarians and even bears have suddenly become ill and are spouting bullish nonsense just like their former equity bull nemeses.


In the newfound lust for the equity markets, everyone is convinced the Fed has some more serious easing ahead.  We agree with that analysis.  To that we enthusiastically exclaim, SO WHAT? 


The thesis of this essay distilled into simple easy to understand logic is (this is for our formerly contrarian and bearish friends… we love and miss you guys and can’t believe you are caught up in and getting excited about the NASDAQ, now trading at over 100x earnings)…


Every so often, naked greed evolves into a speculative mania and begets an equity bubble.  Bubbles are dangerous.  Busts always follow bubbles.  During busts, central banks can give away free money faster than even Democrats in Congress.  By slashing the discount rate, credit becomes so cheap it is practically free.  Yet, in historic bubbles, interest rate cuts do not ultimately do a bit of good.  Bubbles have consequences.  Speculative excesses must be unwound in the busts.  No amount of Wall Street and/or government jawboning, or interest rate cuts, are magic elixirs that can derail the necessary unfolding process of the bust.


OK so far?


NASDAQ 2000 was a bubble, that burst, and is now in the bust phase.  Bubbles have consequences.  This bust will NOT, repeat NOT, be short-circuited by the new easing cycle as Alan Greenspan and the US Federal Reserve frantically try to reinflate a deflating credit bubble. 


History will not be mocked, and this time is NOT different.


We cordially invite our formerly contrarian and bearish friends back into the fold of reason and fundamentals.  The equity perma-bulls are nuts, as their behavior in late 1999 and 2000 exemplified, and we understand why they are excited about a bear market rally.  Yet we fail to understand why contrarians and bears, regardless of the technicals, are ignoring history and true valuation fundamentals and jumping on the popular NASDAQ bull party wagon.


As this week draws to a close and I start my famous lefse production operation for Superbowl snacks, I am SO looking forward to 48 peaceful hours without having to hear the sacred bullish mantra, INTEREST RATE CUTS!


Adam Hamilton, CPA     January 26, 2001     Subscribe