There are some uncanny parallels between what Fed Chief Alan Greenspan did for equities in the ‘90s, and what he’s doing as of late for bonds. Having staked out a “speculation friendly position,” the Fed Chief subsequently reversed himself, leaving fixed income traders to hang out to dry. Hey, it’s the Fed Chief’s prerogative to change his mind . . . But in doing so, he causes massive dislocation in the world’s largest capital markets.

A quick review: In a now infamous 1996 speech, Greenspan said “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” That was widely perceived as a warning that stocks had gotten too pricey for the Fed Chief’s taste. In 1997, he started waxing eloquent on Productivity gains. After then, the “Productivity Miracle” became a fixture in Fed speeches, white papers, and FOMC Meetings. It culminated in the massive 1999 liquidity infusion by the Fed in anticipation of a Y2k run on the banks. That surge in money supply effectively doubled the Nasdaq from October 1999 to March 2000; We need not remind you how that ended.

Fast forward to 2003. The new Fed fear is deflation. For a while, they seemed to have successfully jawboned the bond market into believing that rates would stay low for a long, long time. The Fed Chief even suggested that they stood ready to make open market purchases to ensure rates stay low.

As Bond buyers have discovered to their chagrin, this statement has turned out to be false (at least so far). The fixed income crowd has become Wile E. Coyote to Greenspan’s Roadrunner. The Fed Chief painted a tunnel entrance on a wall, and they ran face first into it. Forgive the equity crowd their snickering, as they had already paid their tuition to learn that costly lesson.

By and large, it’s the ghoul’s own fault. Front running a client is bad form; Front running the Fed Chief turns out to be just plain stupid. After the May 21 Congressional testimony, their buying drove rates down further, removing any need for the Fed to make open market bond purchases. That buying paroxysm was the final thrust of the great 2000-2003 Bond Bull market.

Since then, Bonds have been routed. Yields on the 10 year rose from 3.11% to 4.40%; The long bond rates have spiked from 4.17% to 5.38%. That this move happened in less than 2 months is even more astonishing. The Bull market for bonds is now over, unless the economy rolls over into Stephen Roach’s double dip; Its hard to see that happening anytime before 2005.

The Coyote’s mad pursuit of the Roadrunner occasionally takes him off the edge of the cliff. As long as he remains blissfully unaware of the danger, Wile E. can defy gravity. Its only when the smoke settles and he looks down that his troubles begin. Call it the “Subjective Perception of Reality Principle.” Through enthusiastic ignorance, you can avoid the natural laws of physics, at least on a temporary basis.

Alas, objective reality eventually wins in the end. Once the Coyote discovers he is no longer on terra firma, he plummets to an ignominious end. Just as Stocks did in 2000, and just as Bonds are doing now . . .
The Fed Chief has shown the uncanny ability to say one thing and do another. Traders who hang on his every word, or even take it at face value, soon learn why that’s not a very good strategy.

There’s even a Looney Tunes moral to this story: There’s no such thing as the “Greenspan Put.”

Category: Finance

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