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September 19, 2007

Bernanke Abolishes Corrections and Bank Losses
by Michael Swanson

I was shocked by yesterday's decision by the Federal Reserve to lower interest rates by 50 basis points and then signal that there is more to come in its statement. The Fed is in a tough bind. I know there are frightening things happening in the credit markets and banks and Wall Street is clamoring for rate cuts. We saw the near collapse of Countrywide Financial a few weeks ago and England's Northern Rock has experienced a full fledged bank run. At the same time though inflation is accelerating as oil prices hit all-time highs and gold breaks through $700 an ounce and the DOW is only 1.7% off of its all-time high.

Look the Fed saved the stock market from crashing on August 16th by intervention. We've since seen a rally going up into yesterday's expected Fed announcement while the credit markets continued to deteriorate. The move down in July was the first act of a financial crisis - and normally those unfold in two stages. The first being when people realize there is a big problem causing huge frightening losses the extent of which are unknown and are forcing institutional investors to selling due to margin calls and redemptions.

The second act is when the market finds out how big the losses are and who has them. This is what happened in 1998. The market fell hard in August of that year due to turmoil in the international bond market, bounced, in September, and then dropped hard again to form a double bottom when the Long-Term Capital hedge fund blew up.

If the Fed hadn't lowered interest by .50 basis points yesterday the market most likely would begin a correction by the end of this week that would bring it down to retest the August lows by the middle of October. The market most likely would have then made a double bottom and be geared up to up through the end of the year. If the Fed had to it could have even intervened again to force a bottom.

Just about everyone expected the Fed to lower rates by a .25 basis points yesterday. To me this seemed like the logical thing to do. This way the Fed would save some ammo for later and deliver a message that it was there to step in if needed, but things weren't too serious.

But by lowering rates by .50 points the Fed not only surprised the stock market, which forced shorts to close out positions and caused people to react to the news and create an outsized rally, but sent a very powerful message: The Fed will not allow the market to have a pullback of any sort. The Fed will not allow banks that made bad loans to go under and simply doesn't care about inflation or the value of the dollar at this stage of the game.

I know many people reading this are excited to see the market go up, but you need to step back and think about things for a minute. Why did the Fed do what it did yesterday? What the Fed did is dire, because it is lowering interest rates in a huge dramatic way when the DOW is only 1.7% off of its all-time high and inflation is accelerating. Not even Alan Greenspan did anything like this.

This is one of the most shocking things I've ever seen in the markets. August 16th was shocking. And if you listened to my podcast the following weekend you know it troubled me. I thought the stock market almost crashed that day and I took it as a sign that the macro big picture was changing - that subprime was a true problem in the markets that could lead to a wipeout in the coming weeks. I did not know what was going to happen, but I decided to actually stay out of the markets for the most part until the picture became more clear.

Well, past history suggested that we would see a retest of the lows and the success or failure of that retest would tell us the depth of the credit problems and give us a good idea of what the market would do the rest of the year.

Yesterday the Fed lowered rates by .50 points to shock the markets and force a rally to prevent such a retest. Yesterday is just as dramatic as the market action on August 16th, because it does indeed tell us that the macro picture is changing in a big way. A way that I didn't anticipate, because it is incredibly reckless and dangerous on the part of the Federal Reserve. It is almost insane. It would be the equivalent of George Bush saying "I am losing in Iraq and I need to win a war somewhere so I am going to launch nuclear strikes on Iran so I can go out a winner. Dick Cheney says it is a good idea so it must be." By lowering interest rates by half a point while the market priced in a quarter point drop and the US dollar index is under 80 Bernanke is doing the equivalent of launching a nuclear missile into the financial system.

When the stock market went bust in 2000 Greenspan didn't lower rates to almost a year later and with the Nasdaq almost cut in half. During the 1998 Long-Term Capital Crisis he first cut by a quarter point and then lowered rates later when the market dropped again. The Fed is supposed to lower rates as you approach the trough of a business cycle, not right up near the top when there is inflation. To do so is very dangerous and if Bernanke continues this course he will destroy the value of the dollar. The Fed is saying that it will now print money like mad to prevent any sort of market pullback of any kind and it doesn't care about the value of the dollar. The US Dollar index is trading below its 30 year support level and will eventually collapse if the Fed continues upon the course that it announced yesterday.

And he is sending a message that he is willing to do this.

I can think of only two reasons:

1)The problems in the mortgage markets are worse than we know and the entire banking system is bankrupt. In other words the mortgage securities that banks hold are worth nothing. The Fed in turn is going to print money and lower interest until housing prices go back up, so mortgage securities will rally, and if inflation explodes and the dollar becomes worthless it is worth the cost, because the banks must be saved. And the banks own the Fed.

Of course this seems crazy. Yeah there is turmoil in the banking system, but can it really be that bad? But it would have to be to justify such action on the Fed and even then some would argue that its not worth jeopardizing the dollar to save the banks.

Just because the Fed panics doesn't necessarily mean there is anything to fear. If you recall at the end of 1999 Alan Greenspan pumped the money supply in fears of a phantom Y2K menace. That action helped create the final blow-off for the Nasdaq bubble and made the ensuing bear market worse than it would have been. It was a huge mistake.

If the banking system isn't about to go bankrupt then to cut interest rates at this pace is a mistake that makes the Y2K menace look like a little bruise on a knee.

2)Ben Bernanke has a PH.D in economics and is obsessed with the idea that the Fed caused the Great Depression, because it didn't lower interest rates fast enough. He's an academic who is putting the theories he learned as a young man to use.

I can understand this. I was an academic once. I was in a university PH.D history program and left with a Master's Degree. I know what academic life is about. When you go through graduate school you have to write a doctoral thesis, which will start your real career. Usually those thesis - if they are successful - lead to books and then more writings that branch off of the original thesis. Creative minds, and there is a difference between being imaginative and smart, then investigate new avenues of thought throughout their careers and come up with innovative theories and groundbreaking research.

The unimaginative though spend the rest of their career circling around the theories behind their doctoral thesis. They remain anchored to it and don't actually come up with any new ideas the rest of their lives that amount to anything. They may be successful professionally, but deep down they aren't anything but a one hit woner.

That is essentially what Bernanke is. He wrote a thesis claiming that the Great Depression happened because the Fed didn't lower interest rates fast enough after the stock market topped out in 1929. I don't believe this at all, but to explain why is a subject left for another time. What is important though is that if you look at a chart of the stock market between 1929 and 1932 and look at what the Fed did you'll see that the Fed lowered interest shortly after the market topped out and continued to lower rates in the following years and the market fell anyway. Rates and the stock market fell together.

What this means though is ff you believe the Fed didn't lower rates interest fast enough as Bernanke does then you think the Fed should have lowered rates all at once instead of doing so as the market dropped.

It appears that Bernanke is putting that theory to test right now. At the very least he is trying to prevent the market from reaching phase two of this crisis, in which the extent of the subprime losses are revealed, by restoring the balance sheets of troubled hedge funds with a big stock market rally of his creation.

Based on Bernanke's Depression thesis it seems that he is going to lower rates dramatically and quickly over just a few months, because he believes that if he doesn't the banking system will collapse, the stock market will crash, we'll have a Depression or who knows what. In the end this probably won't make any bit of difference and will cause a hyperinflation of consumer prices and a collapse in the value of the dollar - and may not be even needed at all. He's fearing that the credit markets and banking problems justify such a course of action, but that isn't a 100% certainty. Maybe the problems aren't as bad as he fears. But we won't know that.

Instead a year from now if he continues this course we'll have a different set of problems - a dollar that has collapsed in value and eventually a huge spike in interest rates as foreign investors flee the dollar and the US government bond market.

I almost wish I had no money in my brokerage account or my banking accounts right now and just had a closet full of gold bullion. One could sell everyone one has and put it in gold and not have to worry about a thing right now. But of course gold stocks will go up huge over the next 6-8 months so there is more money to be made in them. I'll just have to buy the next pullback or 1-2 week period of consolidation in them and get on board that ride. But at some point it will be prudent to take profits and move the money into pure gold or a foreign currency as I fear that the dollar could actually become worthless when Bernanke's is done.

Look even Bloomberg has a headline that states "FOMC now stands for Friend of Market Committee" on their website this morning.

Here are some more must read reactions:

Billionaire Jim Rogers before the rate cut in a must see Bloomberg video:

"Every time the Fed turns around to save its friends on Wall Street, it makes the situation worse if Bernanke starts running those printing presses even faster than he's doing already, yes we are going to have a serious recession. The dollar's going to collapse, the bond market's going to collapse. There's going to be a lot of problems in the U.S."

In an article on Financialsense.com Frank Barbera writes:

"Forget about any 'Moral Hazard,' and forget about the purchasing power of those hard earned Dollars. Clearly, that is the message that the Fed is sending to the International community with today's action. A shocking, potentially reckless move, where will the Bid be found on the greenback, and at what point will foreigners decide that a 4.48% yield on a 10 year Bond doesn't cover the bet? (Heck, it ticked up a whole basis point today.) Only time will tell, but for now, the Fed's stark message seems to be re-inflate at all costs. In pursuing this arguably high-risk path, the Fed is opening the door to a potential Pandora's Box. Conspiracy theorists may argue that Central Banks are working together, and that despite a lower value for the Greenback, foreign money will continue to be recycled into US Dollars. Yet, what if that is wrong? What if foreign money decides to flee the Dollar market? In that reality, this high stakes gambit by the Fed could blow up in its face, as exiting foreign capital hammers the Dollar and begins to send long term rates sharply higher. At that point, we face a melt down, as rising long term rates would be another nail in the coffin for the US Residential Market, and could continue to generate chaos in credit markets. A marked departure from the Greenspan gradualism, the Fed appears to be leaving its equilibrium at the political alter of an election year, and at the special interest alter of Wall Street investment banks. How ironic that if presumed foreign cooperation is renounced, the Fed could end up standing alone in a long suffering melt down. Looking back at past interest rate cutting cycles, we see that the trend in the US Dollar has not been anything but ugly. Now, with the US Dollar on the verge of all time record lows against most major currencies, is it possible that today's aggressive rate cut will be seen as anything but an Admiral Farragut style "Damn the torpedoes, full speed ahead" decree of a global "we don't care" weak dollar policy?"

The Fed lowered interest rates with the DOW only 1.7% off of its highs. How low will they lower interest rates if the economy continues to slowdown and real estate prices don't rebound? When will it end? We know the trend now. It is clear what the macro picture has become - the Fed is going to print money like mad and inflation is going to explode. You buy gold, gold stocks, and other commodity stocks to profit from that trend. And at the same time you pray that the trend doesn't run to its final destination.

Everytime that Fed has lowered interest to bail out a segment of the financial markets it has created another financial bubble somewhere else until that bubble had a blow off stage and collapse of its own. When Greenspan lowered rates in 1998 to bail out Long-Term Capital a bubble in tech stocks formed the next year. When that bubble burst in 2000 and he lowered rates to stop the carnage he created a bubble in housing prices. That bubble ended a year ago and when banking problems and the collapse of mortgage securities hit the market as a result in the past six weeks Bernanke lowered rates.

The next bubble to come appears to be gold, commodities, and inflation. If that bubble runs it course and has a blow-off stage it will end with the collapse of the dollar and a panic on the part of foreign investors when it comes to anyone holding US debt and dollars. We may have a time over the next couple of months in which the stock market goes up in dramatic fashion, but at the end game anyone holding their savings and assets in US dollars will be wiped out.

The Fed signaled yesterday that it is willing to take that risk in order to save a bunch of Wall Street banks and hedge funds. Welcome to socialism for the rich. If the dollar goes to nothing hundreds of millions of people will lose their saving to bail out a few Wall Street bankers. It will one of the greatest transfers of wealth in history of money from the poor to the rich.

This article continues in the WSW Power Investor section in a bulletin titled Trading in a Printing Press Environment.

For more updates on the market action and individual stock investment ideas subscribe to Mike Swanson's weekly gold stock report: http://www.wallstreetwindow.com/weeklygold.htm.

Michael Swanson,
WallStreetWindow.com

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