THE ECONOMY: NEW FEARS OVER INFLATION : Same Forces That Pushed Securities Up Now Push Them Down

Don’t blame inflation, the economy or the Federal Reserve Board for the dramatic upturn in interest rates or the downturn in stock prices.

What’s driving markets lower this winter is the same high-octane force that drove them higher last fall: sheer momentum, defined as the weight of billions of dollars of so-called smart money suddenly pushing in the same direction against securities prices.

Last year, momentum took markets worldwide to unprecedented heights. Now much of the money that wanted into securities so badly in 1993 is trying to get out all at once. Predictably, the exit door is too narrow--so sellers are being forced to shrink their cargo (stocks and bonds) to fit.

On Tuesday, 30-year Treasury bond yields surged to an eight-month high of 6.78% and the Dow industrials sank 22.79 points, both ostensibly because of signs of rising inflation in a national survey of corporate purchasing managers. But many Wall Streeters say inflation fears are a red herring. “The fundamentals (of the economy) just aren’t that dangerous,” argues David Jones, economist at Aubrey Lanston & Co. in New York.

For an excuse to sell, however, a whiff of inflation will do just fine now for the kingpins of global trading--multibillion-dollar investors who manage money for the super rich. They’re called “hedge funds,” and they make huge, leveraged bets that straddle markets worldwide.

Most important, they can be notoriously short-term in their trading. They help drive bullish markets sky-high, in the process goading other investors to leap in.

But the price we all pay for such bandwagon investing is vicious selling when the hedge funds decide the trend has been played out.

Early this year, the hedge funds had two major bets going: They had wagered billions of dollars that U.S., European and Japanese bond yields would continue to drop and that the Japanese yen would weaken dramatically against the dollar, as Japan wallowed in recession.

They seemed to be logical bets. However, what the funds hadn’t counted on was that the Federal Reserve would choose to tighten credit at the same time that the White House would decide to crush the dollar’s value (thus strengthening the yen) in an attempt to bash Japan into opening its economy.

As interest rates turned up early last month and the dollar fell, hedge fund giants such as George Soros, Julian Robertson and Leon Cooperman were blindsided. And because so much of their trading is with borrowed money, their losses mushroomed.

Paul Singer, a New York-based fund manager who addressed a conference of high-powered money managers in Newport Beach on Monday, reminded his audience that the hedge funds’ $30-billion to $40-billion total in capital actually becomes $300 billion to $400 billion with leverage.

With far too much at stake, these traders can’t afford to stick around when the tide turns against them. They have to cut their losses in a hurry. Forced to raise cash to close out their bets, the hedge managers have been wildly dumping foreign and U.S. bonds, driving yields sharply higher.

That, in turn, has helped undercut stocks worldwide, particularly in emerging markets where shares had zoomed to record heights last year (in part, also courtesy of hedge fund money).

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Meanwhile, the about-face in bond market momentum from wild bullishness to distressed selling has frozen non-hedge investors--buyers who tend to have much longer time horizons--in their places. Despite hedge fund money’s savvy reputation, it doesn’t always make the right market calls, especially in self-induced panics. Fundamental investors know this, and many of them believe long-term interest rates now have run up too far, too fast.

Yet they aren’t buying bonds. Neither, however, are most fundamental investors selling. “I think what we have so far is a reality check,” says Marshall Acuff, investment strategist at Smith Barney Shearson in New York. “In the institutional investor community, I’m finding a lot of talk about things--but no action.”

Here’s what troubles Wall Street: A lot of the institutions that are so far sitting tight are mutual funds, which attracted record sums last year from individual investors. The funds have no great need to sell stocks or bonds unless their investors dial up and ask for their money back.

At this point, individual investors aren’t sellers. But they may have taken the first step in that direction by significantly reducing their purchases of stock and bond funds from January’s record levels, in favor of safer alternatives:

* Vanguard Group in Valley Forge, Pa., says its cash take fell from January to February and that, in a real surprise, more than half the cash that did flow in last month went into money market funds.

* The Scudder fund group in Boston said its money funds took in $163 million last month, the biggest gain in at least a couple of years, while the firm’s bond funds experienced “modest” outflows.

* The Franklin fund group in San Mateo, Calif., echoing Vanguard, says more than half its new purchases last month were in money funds.

As everybody knows, small investors have been conditioned to buy on market dips. “Individuals have acted as the stabilizing influence in every market setback of the last couple of years,” notes Arnold Kaufman, editor of Standard & Poor’s Outlook investment newsletter. Those money flows have held market volatility to record lows.

But this time, the shift in market momentum driven by the hedge funds and other speculators has been shocking enough to cause many people to run for cover, not for their checkbooks.

It’s early in this decline, of course. Assuming interest rates and stock prices stabilize soon, there’s good reason to believe that many investors will be lured back to markets that now are 3% to 20% cheaper than they were at their recent peaks.

What won’t go away is the awareness that momentum investing cuts both ways, and that volatility isn’t dead after all. Welcome back to the real world.

* TORRID GROWTH: The economy rocketed forward at a feverish 7.5% rate in late 1993, its best performance in 10 years. A1

Stocks’ Global Malaise

Rising interest rates, trade war worries and simple profit taking have dragged many world stock markets lower this year.

Market (Index): Year-to-date change U.S. (S&P; 500): -0.4% Mexico (Bolsa): -3.4% Britain (FTSE-100) -4.3% Germany (DAX-30): -8.8% Taiwan (Weighted): -10.1% Malaysia (KLSE comp.): -12.7% Hong Kong (Hang Seng): -14.6% Thailand (SET): -18.2%

Funds’ Last Hurrah?

The Investment Company Institute reported Tuesday that mutual funds saw record inflows of money in January--before stock and bond markets cracked. A look at January fund data:

* Gross purchases were $56.8 billion, up from $55.8 billion in December and $37 billion in January, 1993. These figures are adjusted to include, for the first time, data from the College Retirement Equities Fund, a huge pension system for teachers.

* Net new cash flow into the funds, which is net purchases adjusted for exchanges among funds in the same families, less reinvested dividends and redemptions, was $29.2 billion, up dramatically from $20.5 billion in December and $21 billion in January, 1993. These figures essentially show the net increase in investment purchasing power at the funds.

* Net new cash flow into stock funds was $18.3 billion, compared to $14.7 billion in December and $10.3 billion a year earlier; net new cash flow into bond funds was $10.9 billion, compared to $5.8 billion in December and $10.7 billion a year earlier.

* The average stock fund had cash equal to 8.3% of assets in January, up from 8.0% in December. That suggests the funds have plenty of free cash to throw at stocks if they so choose.

Source: Investment Company Institute