The Wednesday Letter #238 - 9/18/2024

THIS WEEK: From Fed Capture to Fed Quandary; About Gold: Courting Disaster x 4; German Navy; The Coming US Economic Boom*.

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FROM FED CAPTURE TO FED QUANDARY

In early 1999, I was an equity portfolio manager at a New York hedge fund, This was a period like today when the market was wondering about the Fed’s next move. During the fall of 1998, a few months earlier, the Fed had cut the target on the fed funds rate three times in order to contain the collapse of Long Term Capital Management (LTCM) and to restore confidence in the economy and market. Along with the bailout of LTCM which was also organized by the Fed, the cuts worked well to effect a recovery in the stock market. The major indices had fallen 20% or more during the summer and they bounced back rapidly in the fall.

Market sentiment was more or less back to normal in the early weeks of 1999 and the mood among investors was increasingly bullish. One day, I happened to have a conversation with a colleague during which I wondered whether the Fed would surprise the market by raising rates, essentially taking back its emergency rate cuts now that the crisis had passed. My colleague, a seasoned market veteran, did not think this a possibility and said nonchalantly that the Fed had “learned their lesson in 1994.”

In 1994, the economy was coming out of a period of low interest rates and the Fed hiked rates aggressively, from 3% to 6% over a sixteen months period. The effect on the market was mixed. The stock market ended 1994 close to flat, though it had been volatile all year. But bonds sold off hard, with the entire yield curve rising and becoming less steep (long duration yields rose less than short duration).

My colleague was right that something had changed in 1994, and again in 1998. Until then, the Fed was more opaque than it is today and it did not mind surprising the market with a rate hike or rate cut. Such surprises were normal through the early years of Alan Greenspan during which the Fed kept the market guessing about its targets and intentions. Greenspan himself joked about it in 1987:

Since I've become a central banker, I've learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.

But in Greenspan’s later years as chairman, after a series of crises — the Mexican peso devaluation in late 1994, LTCM in 1998, the dotcom bubble of 1999-2000, the attacks of 9/11 —, the Fed started to give more indications regarding the timing and extent of its actions. There were a shift and a new trend developing, with the Fed signaling frequently to the market. The Clinton administration’s closer relationship with Wall Street, and the appointment of Goldman Sachs’ Robert Rubin as Treasury Secretary further encouraged this new openness and communication between DC and Wall Street. It was around that time that people started talking about a Greenspan put.