How to Calm Global Financial Markets?

October 8, 2008

The reason for the global financial crisis is negative interest rate spreads, i.e., the lowering of interest rates below the normalized annual rate of inflation running globally at about 5.5%-6.0%. The Federal Reserve Bank must publicly admit that by bringing the Fed Funds rate below the rate of inflation that it has in effect created negative capital flows whereby capital taken from bond markets to invest in stocks markets to benefit from the temporary rise in stock market prices (which acts as an hedge against spiraling inflation under a trading strategy that returns invested capital back to bond markets) suffer imminent depreciation when prices on the stock market falls as investors take profits and return to safe heavens in government-backed bond markets. This creates a never ending loop or cycle of free falling debt and equity values until the cycle stops or is broken.

This is not a psychological phenomenon, it is structural, and the solutions used to fix the problem must be structural as well.

To arrest the problem in the most expeditious and effective manner possible, the Federal Reserve Bank must publicly announce its intentions to raise the Fed Fund rates as quickly as possible to a level that is 2%-3% above the annualized global rate of inflation in order to:

  1. Instill calm in financial markets by making known its intention to once again build, secure and maintain real value in financial markets that can act as a countervailing measure and support for promoting “real” organic growth in the stock market.
  2. Give assurance to the public and investors that the root cause of the problem in financial markets has been identified and is being addressed.
  3. Assure the public and investors that positive capital formation will start again soon in financial markets by the Fed and Central Bankers around the world that would stem the outflow of accumulated value created by workers and laborers of the global world economy who uses capital goods, technology and equipment to create wealth for passive and inactive shareholders who have come under the direct control and direction of sophisticated and politically connected financial technocrats.

The problem is that the U.S. Federal Reserve Bank and Central Banks around the world have lost their ability to influence or control interest rates at all levels of the domestic and global economy. These interest rates are now being set by international financial markets through arbitrage from one currency to another accommodated by the use of swaps and derivative products. For the most part, the Eurodollar and LIBOR rates are driven by forces outside of Central Bankers’ control – even when interest rates are lowered.

When money is removed from the debt market through sale or loan of T-bills and bonds to generate cash to invest in the stock market to take advantage of the temporary rise in stock prices that comes after an interest rate cut by the Fed, those stocks are later sold in 5-10 days time to reinvest back into perceivably more secure bond markets in order to maintain liquidity and stabilize portfolio positions. In many cases, the value return from a temporary foray into the stock market is often at a loss causing a real depreciation or fall in the value of global markets and portfolio positions. But this is not seen as such by traders and investors but rather as a change in global market position. This never ending cycle is repeated time and time again by portfolio managers each time there is an interest rate cut by the Fed. The result is an imminent fall in values in both the stock and bond markets, especially when net interest spreads are negative vis-à-vis inflation.

This phenomenon is not readily perceptible by financial analysts who do not sufficiently discount the value of money transferred from one market to another given the share volume of transactions and continuous and oftentimes liquid flow of funds from one market to another that takes place in real time all over the world.

As a result, one may see a net increase in total stock asset portfolio when operating in the stock or commodities markets or a net increase in portfolio values when operating in the liquid assets or debt markets due to intrinsic and complicated free flowing transactions between the bond and stock markets, accommodated by swaps and other derivative instruments, when in fact there is an inherent decline in the real as opposed to the nominal value of money over any given trading period during any two consecutive interest rate cuts, producing a strong negative multiplier effect over one or more interest rate cut periods. This phenomenon can be likened to rowing a boat faster when going down a steep waterfall thinking at all times that you will ultimately gain control of the speed and direction of the vehicle instead of wisely using the rows to slow down or retard the speed of the boat in an effort to gain greater control.

This is essentially the cause for the crisis in global financial markets and until the crisis is arrested by Ben Bernanke publicly announcing and following through by raising the Fed Funds rate to an acceptable level that is commensurate with the real cost of capital that factors in the cost of inflation as an important base denominator, the problem will persist until there is virtually no value left in financial markets, meaning total collapse leading to irreversible recovery.

It is important that the Federal Reserve Bank supported by the Treasury and Bush Administration make the above statement and raise the Fed Funds rates as soon as possible in order to bring calm and stability to global financial markets.

Stock Market Crash – Robert Prechter on Bloomberg – Oct. 19, 2007

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