The Birth of the Fed’s Most Dangerous Weapon

March 21, 2023

It was a Monday in October like any other when the stock market began a small but persistent trend lower. The S&P 500 closed down five straight days giving up just over 5% of its value. Given the market was in the middle of a 5-year bull trend, it didn’t raise an eyebrow.

The following Monday the trend lower continued. But on Tuesday the market rebounded, closing on its highs. Still no one blinked.

What happened after that is history. 

On Wednesday the market reversed back lower, and gave up 33 index points (just over 10%) over the following three days. This time the sharp move down caught the market’s attention. 

Nobody was ready for what happened when the market opened the following Monday, October 19… The market collapsed 58 index points — nearly 21% — in a single day.

To put that one-day move in context, the S&P 500 would have to drop nearly 1,000 index points in a single day today. 

On Tuesday the market spiked to a low of 216 — 34% off its October 5 high, and promptly reversed course finally closing higher on Tuesday. It started back lower into the following week before finally stabilizing.

Those five trading days became known as the Crash of 1987.

The event left traders, investors, exchanges, clearinghouses — the entire financial world — stunned.

Extreme Crises Call for Extreme Fixes

Just two months earlier, Alan Greenspan started his new gig as Chairman of the Federal Reserve. He was about to give a speech to a group in Dallas when Washington reached out to advise him of the crisis.

Aside from wishing he never took the job (I’m guessing), Greenspan understood what the big threat of this situation was…   that financial institutions wouldn’t transfer funds they owed to other financial institutions, because they couldn’t be sure other institutions would transfer funds owed to them. In other words, that the flow of capital would come to a standstill.

He and his associates came up with a plan and issued, in his name, a one sentence statement on October 20 before the markets opened…

“The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”

According to the Richmond Fed:

…the Fed backed up that promise. That day and for the next two weeks, it made millions of dollars available to banks through its open market purchases. The purchases were significant and frequently made at an earlier time of the day than usual to assure markets that liquidity was available.

Any further crisis was averted.

That was the birth of the “Greenspan Put.” 

A Cure Worse Than…

A “put” is a financial instrument that protects an investor from downside risk. 

Alan Greenspan’s massive injection of liquidity into the market did just that.

Unfortunately, it worked so well it became the de facto response to any and every financial crisis (and even near-crisis). Throw money at the market. 

And like any overused medicine, the curative effects diminish until, given in too large doses, it becomes toxic. 

Today the Greenspan (now known more generically as the “Fed”) Put has effectively created more trouble than it’s fixed. Excessively cheap capital has led to excessive risk taking. And the knowledge by market participants that if they get in enough trouble has created an even more dangerous condition known as “moral hazard.”

The Fed, like the Plunge Protection Team, is always there to bail out the market.

Unfortunately, as I’ll explain in your next letter, that’s not always a good thing… 

Make the trend your friend,

Bob Byrne
Editor, Streetlight Daily