Greendoom: Much Ado About Something?

February 6, 2004

The most recent outbreak of what some have taken to calling “Greendoom” — borrowing from the Internet virus Mydoom — occurred on January 28, 2004. On that day, the Fed issued a statement declaring “patience” with their accommodative interest rate policy. The previous few months they had said they would wait “a considerable period of time” before initiating change.

The market reaction was swift: the U.S. dollar immediately gained 1%, and the Dow Jones Industrial Average (DJIA) closed down 141.55 points on the day.

And that wasn’t the first outbreak of Greedoom. In December of 1996, Chairman Greenspan asked, “How do we know when irrational exuberance has unduly escalated asset values?” The following day, the Dow Jones Industrial Average plunged 145.35 points in the first 30 minutes of trading. While the destruction wasn’t long-lived, the reaction surprised nearly everyone. Since then, Greenspan’s words have made markets jelly-legged and pundits absolutely rabid.

Is this latest Fed inspired upheaval merely a case of much ado about nothing? To answer that question, it is instructive to look at the situation facing the Fed Chairman in an historical perspective.

Mr. Greenspan has a finger on the trigger of interest rates at a time when suppressing rates isn’t easy. Glossing over the fact that rates are at historical lows (making rate declines close to impossible), the dollar has recently plunged against most major currencies, dropping over 30% against the Euro (yet having no appreciable effect on the mega-sized balance of trade deficit). If the greenback becomes much sicker, higher rates may be the only medicine for attracting international investment. The U.S. is also facing budget deficits in excess of $500 billion a year. To finance these deficits, the Treasury must sell bonds – increased supply, everything else being the same, means higher rates to attract additional investors. Finally, the economy is showing signs of recovery. The specter of early 1980’s double-digit inflation has kept Mr. Greenspan perpetually wary of unfettered expansion.

In sum, Mr. Greenspan must play the interest rate cycle like a three-star chef betting his life on executing a four-star economic soufflé. Waiting too long to raise rate risks over-inflating the dish; acting too early may flatten it. To further complicate the recipe, this is all happening in an election year amidst cries of partisanship.

A study of the recent past is unlikely to make the chairman any more sanguine about the current environment. Active in capital markets as an academic and practitioner in the early part of 1982, Alan Greenspan witnessed dull markets, investor apathy, and dead money. The U-turn didn’t come until lofty interest rates began a massive reversal, pulling bond and equity prices to unimagined levels. These rate declines — The Little Engine that could — set off a bull market to rival no other.

While some may debate the direct cause and effect of rate declines to asset appreciation, none can deny the correlation. From 1982 until December of 2003, the Prime Rate declined from over 20% to 4%, while the DJIA rose from just over 800 to over 10,000. It is doubtful that Mr. Greenspan believes the correlation coincidental. Better than anyone, he understands how interest rates influence the cost of capital, induce shifts in investments, and determine the discount level on future earnings, dividends, and overall rates of return.

Not that it is necessary, but if Mr. Greenspan had any doubts about the market impact of rising interest rates, he can draw on personal experience. In February 1994, Mr. Greenspan stunned investors by raising short-term interest rates one quarter of one percent (25 basis points). Over the course of the next two months, the 30-year Treasury bond tanked, and yields rose from 6.2% to 7.6% (a whopping 140 basis point increase). The supposed smartest of the smart — hedge fund managers Michael Steinhardt and George Soros — reportedly lost $800 million and $650 million respectively in the aftermath. It is unlikely that Mr. Greenspan forgot the leveraged impact of that FOMC decision.

So, when discussing interest rates, it must feel to the chairman that he walks on eggshells resting atop broken glass. With that in mind, the substitution of “patient” for “considerable” may indeed be signaling a significant policy change. If so, who can blame Mr. Greenspan for introducing the concept in small doses, as if trying to slowly inoculate the market against the inevitability of rising interest rates and pandemic Greendoom?

As for me, I’m assuming that’s exactly what’s happening. With economic duct tape, plastic wrap, and survival kit ready, I’ll continue to consult my Greenspan tea-leaves every time he opens his mouth. In the case of our Fed Chairman, a word (to turn a phrase) may be worth a thousand pictures.