Proof of Manipulation

How very interesting it was to see a reputable financial publication addressing an issue that has been highly debated among gold bugs in recent years, but never formally substantiated. Specifically, the article was in reference to the Federal Reserve's policy of artificially supporting the U.S. financial system to prevent catastrophic outbreaks such as has occurred to Japan's financial system or the economies of certain South American countries. Of course, the term "Plunge Protection Team" has been bandied about for years among Fed watchers and others leery of federal interference in the stock, bond and gold markets, and it is widely known that the Treasury Department regularly engages in the practice of buying S&P futures whenever the equities market is on a precarious footing. Yet now we have more insight into these manipulative practices. Of even greater interest is the reference the article made to the Fed possibly buying gold mines for purposes of supporting the economy if it ever came to that.

According to a March 25 article appearing in the Financial Times, "The US Federal Reserve in January considered a variety of "unconventional" emergency measures to be taken if cutting short-term interest rates failed to arrest a U.S. recession and prevent Japanese-style deflation. One of those steps may have been a plan to buy U.S. stocks."

The article went on to say that according to minutes of its January 25-26 meeting, the Fed's policy-making Open Market Committee agreed "unconventional policy measures might be available" to deal with a situation in which "the economy were to deteriorate substantially in a period when nominal short-term interest rates were already at very low levels", although, it said, the efficacy of such measures was "uncertain". The minutes vaguely mention internal analyses of such a scenario.

The article reported that the Fed's discussion appeared largely academic, conducted at a time when the year-long recession was drawing to a close. But the topic was apparently brought up in the context of concerns that the U.S. could have faced-and might face in the future-a dilemma in which short-term interest rates were so low as to be rendered ineffective as a monetary policy tool.

Minutes which summarized the meeting were released in March. A full transcript will not be available for five years but a senior Fed official who attended the meeting told the Times that the reference to "unconventional means" was "commonly understood by academics". The official, who asked not to be named, would not elaborate but mentioned "buying US equities" as an example of such possible measures, and later said the Fed "could theoretically buy anything to pump money into the system" including "state and local debt, real estate and gold mines-any asset".

The Fed currently relies on the buying and selling of Treasury bonds as a way of targeting short-term interest rates. The article noted that in its fight against last year's economic downturn, the Fed has reduced the Fed funds rate from a 10-year high of 6.5 per cent to a 40-year low of 1.75 per cent. The moves prompted speculation last year among some economists that short-term interest rates might at some point hit zero and that interest-rate policy might become useless.

For the last 10 or 15 years the Fed has attempted to keep the system afloat through stock market and interest rate manipulations. But those time-worn weapons have lost much of their effectiveness over the past two years (as evidenced by the tech stock bubble implosion among other things), so the Fed has turned its attention to other major economic components that can be artificially propped up in time of need.

One such major financial sector that has come under the Fed's watchful eye and has been a product of "bubble" valuations recently has been the real estate market. Housing and prime real estate have undergone a mini-boom since the September market bottom and in some locales real estate and housing prices are at all-time high levels and show no sign of let-up. The prime benchmark for the real estate equities, the Morgan Stanley REIT index (RMS), as of this writing has just set another high and just keeps climbing. This seemingly unstoppable rally among the REITs has triggered another wave of investor enthusiasm for real estate equities, as evidenced by the recent attention the sector has been given by the financial press. Beginning a couple of weeks ago several major financial news sources began stepping up coverage of real estate and real estate equities. As one example, CBS Marketwatch.com is now offering investors a free weekly newsletter focusing solely on the real estate market. Leading Internet search portal Yahoo.com is now prominently displaying real estate market on its home page, making it easy for investors to access the latest news and price trends.

This increased mainstream coverage of the REITs now ensures that the real estate bubble will soon develop into a full-blow bubble mania. The Fed is now actively involved, which guarantees the bubble will continue to grow to unsustainable proportions. Whenever the Fed injects massive amounts of liquidity into the system it always gets funneled somewhere and creates "pocket inflation," that is, inflated values in a specific financial sector (although not necessarily full-scale economic inflation). The Fed's massive money creation of the past year has obviously been funneled largely into real estate and REITs. We were obviously wrong in forecasting the real estate collapse to begin in the first quarter of this year, and looking at the charts it is obvious there is room for at least one final parabolic blow-off before the ultimate top is in. How far off we were in our forecast remains to be seen, but there can be no doubt that the real estate sector is a prime candidate for deflation (a harbinger of which we saw last year) and we wouldn't be surprised if the down-turn coincides with the autumn crash the cycles are forecasting. Assuming this happens, this will represent the beginning of the real estate bubble collapse, which will take many years to deflate.

From the observations and experiences of the past few years, it is obvious that the Fed has greatly improved upon the art of economic manipulation. The Russian economist N. Kondratief, who discovered the long-wave economic cycle which bears his name, lost his head for telling Stalin that central banking and government manipulation could not alter the K-Wave. In his time that was true, but today that is no longer the case. Clearly, the Fed has mastered the art of K-Wave manipulation, and although unable to ultimately destroy the cycle or repeal all of its effects, it can greatly impact its amplitude and duration, even to the extreme of contracting or expanding its bottoms by as many as 20 years! A recent market note from respected cycle analyst Samuel J. Kress illustrates this point:

"Unfortunately, unlike market cycles whose durations are precise, the K-Wave varies in extremes from 40-60 years. Its previous bottom was the late 1940s/early 1950s. Typically, it should bottom between 2004-2006. However, since the great depression of the 1930 with the New Deal, government has consistently intervened with efforts to manipulate the economy. The last event bureaucrats want to develop is to have their tax base go south. Their continuing efforts could protract inevitability until the aforementioned 2011 peak. From the present, this would imply a massive 2,000-3,000 point Dow trading range for the next 9 years. On the other hand, if natural forces prevail and the K-Wave bottoms in 2004-6, this would imply an economic contraction of 4-6 years. It is interesting to note that the depth of the depression occurred in 1934, 5 years after the market crash of 1929."

At any event, navigating the financial climate of the next few years will take considerable skill and dexterity, not to mention timing. No trading operation should be confined solely to a single market, whether stocks, commodities, gold, real estate, etc., but the successful trader in coming years will have to be "jack of all trades" in being able to jump from one sector to another in order to keep ahead of the Fed. In our lifetime we have witnessed the forces of organized banking and government interfere with the formerly free markets to an unprecedented degree, and our generation will reap the bitter consequences of it. Fortunately, there are still ways of profiting from the system while at the same time avoiding its ill effects. The years ahead will certainly be interesting and trying times to say the least.