FEDWATCH: THE GREENSPAN MARKET
Just prior to Fed Chairman Alan Greenspan’s semi-annual Humphrey-Hawkins testimony this week on the outlook for monetary policy and the U. S. economy, we expressed the tiny hope that he would find a way to split hairs on the side of monetary ease. He obviously did not and the markets responded accordingly. Since he began before Senate Banking Tuesday morning, gold is down nearly $3 an ounce, the dollar is up by about two yen, bond yields have dropped about four basis points, and the Dow Industrials have fallen by more than 250 points. From our perspective these are all, in one way or another, indicative of the wrong-headed course the Fed is now committed to maintaining. The divergence between the response of the debt and equity markets is particularly instructive. The clear implication of Greenspan’s message, that while no easing is in store, neither is an immediate tightening, was enough assurance to allow bond prices to post their biggest gain of the past month Tuesday, with the 30-year yield falling back to 5.67%. Without significant risk of a near-term hike in the 5.5% nominal funds rate, bond buyers are encouraged again to capture the real-yield premium that the Fed’s deflation-biased policy stance has made available in long-term Treasuries.
For stocks, though, the Greenspan scenario is considerably more problematic. Although there was little indication in recent trading that the market was actually expecting the monetary focus to shift toward ease, Greenspan’s continuing preoccupation with a phantom inflation carries significant risk for equities. As it is, the Fed’s too-tight policy stance has been disproportionately punishing the riskiest stocks. The low-cap Russell 2000 is down more than 8% in the last three months, a period during which the S&P has posted net gains of more than 3%. We continue to believe the bottom of the economy is damaged most by the Fed’s monetary deflation. The deterioration in the Russell 2000 relative to the high-cap S&P 500, by the way, has closely correlated with the more-than $20 per ounce gold price decline from just below $315 since April. But if Greenspan, as his testimony suggests, is really convinced that sustained, 3%-plus growth ipso facto is an inflationary threat ultimately requiring a policy response, the robust discounting of growth expectations even in larger-cap stock valuations will have to be marked down significantly. Thus would Greenspan’s warnings of “unrealistic” earnings growth assumptions become self-fulfilling.
There’s always the possibility Greenspan purposely talked down the market to appease the FOMC members concerned about asset price “inflation” and other such distractions. The manner of his exposition and response to questions indicates he shares these views to some degree, which is what really must worry the markets. By now, Greenspan’s penchant for growth regulation should come as no surprise. But we are struck by his total abandonment of the gold price signal, which over the years he repeatedly told Congress was a primary signal of inflation expectations. We’re equally struck by his eager embrace of the neo-Keynesian fallacy that labor market conditions are the quintessential gauge of monetary policy. While expecting the economy to cool significantly from the robust pace of the past several quarters, the FOMC “believes that given the current tightness in labor markets, the potential for accelerating inflation is probably greater than the risk of protracted, excessive weakness in the economy.” His only bow toward the possibility of ease was on the remote possibility that the Asian crisis will have a substantially greater-than-expected impact on domestic “aggregate demand.” There were mentions of positive productivity gains throughout his two days of testimony, but while he gave with one hand, with the other he took away. At one point, he even argued that the recent capital-induced rise in labor productivity is a potential threat! “For businesses, decreasing costs of and high rates of return on investment, as well as the scarcity of labor, could keep capital spending elevated. These factors suggest some risk that the labor market could get even tighter. And even if it does not, under prevailing tight labor markets increasingly confident workers might place gradually escalating pressures on wages and costs, which would eventually feed through to prices.”
Still, Greenspan’s acknowledgment that the inflation threat at least is not significant enough to act on yet has allowed the trading range for bond yields to move an increment lower. From here, though, the upside in bonds appears limited. With the 10-year/2-year yield curve inverting slightly once again, and both issues inverted relative to the funds rate, it’s hard to see yields on longer-term, higher-risk issues continuing to move lower. Until some expectation of ease starts coming into the market, the 5.5% funds rate will remain the largest single obstacle to further significant bond gains.
A POLITICAL NOTE
What’s most discouraging is that no member of either Senate or House banking committees tried to pin down Greenspan on the myriad contradictions in his positions. If he could tell Congress when gold was at $385 that the gold price was an exemplary commodity signal of inflation expectations, why would no member ask him why gold at $295 would still signal inflation? When the price indices show no upward movement at all, essentially zero inflation, why would they not ask him about the need to keep the Fed funds rate at 5.5%? Why would no member recall Greenspan’s campaign to persuade Congress that the Consumer Price Index overstates inflation, which would mean the CPI now really signals falling prices? With small farmers, small bankers, independent oil and gas producers, and commodity producers of almost all variety being squashed by the Fed’s deflation, why is it their representatives in Congress or the Washington lobbies are not threatening to tar and feather the Fed chairman?
The answer, of course, is that Greenspan and the Treasury Department have successfully marketed the idea that the collapse of commodity prices has been caused by the Asians -- and that if the farmers, bankers and oil and gas people want higher prices, they must persuade Congress to give $18 billion of taxpayer funds to the International Monetary Fund. In his testimony, Greenspan made every effort to discourage Congress from trying to exact “reforms” from the IMF as its price for the $18 billion. There was good news on this front yesterday when House Speaker Newt Gingrich put the IMF on ice until September, a victory for Majority Leader Dick Armey, who came close to throwing in the towel last week. If the farm and oil interests would get behind Armey instead of fighting him, the GOP congressional leadership could extract major reforms in policy and personnel when the issue comes up in September. As for Greenspan, it should now be obvious there is no chance of getting him to end the deflation unless he comes under political attack from serious people.