In the second quarter of 2000, many investors were still convinced that the retreat from record highs was temporary. In fact, I remember the usual claim that “after such a big run, it’s only normal to have a pullback.” To many permabulls, April, May and June of 2000 were providing “great buying opportunities.” Sound familiar?

As the economy slowed from about 5% GDP growth in Q2-2000 to less than 2% in the 4th Quarter 2000, suddenly everyone seemed to agree it was time for the Fed to cut rates. There were denials about the probability of a recession and more importantly, when the rate cuts came in I remember hearing about an economic and market recovery that was 6-9 months away. At first, it was expected that the summer of 2001 would be the time for a rebound. It didn’t happen, so suddenly the date got pushed back again and again. Investors kept believing the good old days were always just 6-9 months away. Sound familiar?

If not, here is a great reflection from an excerpt of a 2002 speech by William Poole, President of the St. Louis Fed (click here for full text)

The Fed has room to act, but does it have the knowledge to act? It has been well documented that forecasters, including Fed forecasters, have great difficulty predicting the turning points of business cycles, or even recognizing them soon after they occur. Hence the best that can be reasonably expected is that the FOMC would be able to initiate policy actions several months in advance of cycle turning points, or to adjust policy on the basis of accumulating evidence to help reduce the magnitude of a recession once one is observed as having started.

The most recent cycle is a useful example of exactly this process. The business cycle peak is dated in March 2001. The FOMC started lowering the intended funds rate at the beginning of January 2001, a two-month lead on the cycle turning point. At the previous meeting in December, the FOMC had indicated its concern that the economy might be weakening with this language in its policy statement:

“Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee consequently believes that the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.”

As will be clear if you read the FOMC’s published minutes over the course of last year, the Committee did not foresee the extent of the downturn. But over the course of the year the Committee did sense the continuing weakness and did respond readily to incoming information suggesting that the expected revival of activity was not occurring.

My interpretation of these events is that in 2000, especially toward the end of the year, the bond market sensed that the economy was weakening. The decline in the nominal yield was almost entirely due to a decline in the real yield. We know that to be the case from observing the behavior of indexed Treasury yields, which provide a direct market reading on the real rate of interest. This observation fits in with my earlier comment that the real rate of interest is related to the rate of economic growth.

Still, the market would not have bid down long rates in the absence of an anticipation that short rates, controlled by the Fed, would be falling. In fact, the market expected that the Fed would respond to the weakening economy; long rates came down during 2000 in anticipation of the action that the FOMC subsequently took. The timing of the Fed’s January 2001 rate cut took the market by surprise, but not the fact of the cut. Moreover, once the rate cuts began, the odds on a revival of economic activity rose, which I believe is why bond rates did not fall as the FOMC cut the intended funds rate repeatedly over the course of the year.

All during the course of 2001, up to the time of the terrorist attacks in September, current data came in generally weaker than expected but forecasters kept expecting that the economic recovery was just around the corner. The Fed responded to the weaker data by cutting the funds rate aggressively, and the bond market responded to those cuts and the expectation of economic revival by holding long rates in a relatively narrow range.

Moreover, there were a number of instances in which data releases suggested that the economy might see a revival fairly quickly, and these tended to keep long rates from following the declines in the federal funds rate. Let me cite just one example of many. On Friday, April 27, 2001, the 10-year Treasury bond yield jumped by 14 basis points, a large change for a single day. The market was responding to the release of the GDP estimate for the first quarter, which showed growth at a 2 percent annual rate. That was an increase from the 1 percent rate in the fourth quarter, and double the increase that the market had been expecting. In reporting on market activity, the Wall Street Journal said that, “many already had been wagering that the Fed’s aggressive monetary easing this year would spur growth and spark a rebound in stocks before long. … Now, analysts say, the Treasurys market could face a painful period in which yields continue to ratchet higher, the Fed eases less and people pull money out of bonds in anticipation of a continued resurgence in stock prices.” (April 30, 2001, p. C15)

The view that economic revival was just around the corner remained into early September. However, when the terrorist attacks occurred, the outlook suddenly looked much worse. The Fed cut the intended funds rate sharply further, and bond rates fell to what turned out to be their lows for the year as forecasters revised down their employment and output forecasts.

Fun trip down memory lane - isn’t it?

One of the things that bugs me the most about the similarities of economist and investor behavior between now and then is the proclamations by many “clairvoyants” of when we will see a recovery. Once again, I keep hearing things like “economic weakness will last for another 6 months and then we will come out of it.” Evidence? Do they have any evidence? What is this based upon? These morons weren’t predicting a recession 6 months ago, how the hell am I supposed to believe they can now predict when it will end or how severe it will be!?! These are all rhetorical questions. NO ONE knows.