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TURMOIL IN THE MARKETS : Did Fed Play Its Hole Card?

Trying to explain the extraordinary upheaval in global financial markets over the past month, some Wall Streeters are posing an intriguing question:

Were world stock and bond markets riding atop a dangerous speculative bubble before this--and did the Federal Reserve Board understand this and vote to willfully prick that bubble?

On the surface, the Fed’s decision to boost short-term interest rates by a quarter-point on Feb. 4, the first such credit tightening in five years, was a function of the U.S. economy’s robust growth. The Fed wanted to preempt the rising inflation that often follows economic booms.

But at the same time, the central bank was obviously aware of the unprecedented flow of dollars plowing into foreign stocks and bonds over the past six months, driving share prices up 50% to 100% and bond yields way down.

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Much of that money, from both professional “hedge funds” run by heavily leveraged global traders and from mutual funds flush with dollars from average Americans, was increasingly being targeted at extremely high-risk emerging markets, from Southeast Asia to Latin America to Africa.

Moreover, the Fed and other global central bankers have been quite vocal about their concern over the mushrooming use of often-shadowy derivative securities worldwide.

Derivatives, which include options, futures and a host of related “synthetic” securities, allow traders to make bets on stocks and bonds with little money down, or to hedge themselves against market declines and thus maintain bigger positions in stocks and bonds than they otherwise might.

If Fed Chairman Alan Greenspan wanted to send a signal that would prompt big investors to tone down their level of speculation in red-hot markets around the world, including in the United States, nothing would be more effective than a move to tighten credit.

Higher U.S. interest rates, after all, immediately boost the cost of leverage--the billions in borrowed bank dollars used by hedge funds and others to magnify their market bets.

At the same time, higher U.S. rates would be expected to stem at least some of the tremendous dollar flow to overseas markets, by making U.S. money market instruments and bonds more attractive. If the Fed were concerned about keeping the U.S. economy’s recovery on track, one key would be to avoid sudden artificial shortages, including shortages of capital.

Did the Fed believe a bubble was forming in financial markets? Greenspan hasn’t said so publicly, but perhaps he didn’t have to.

“Everybody knows we’ve been pushing the envelope with valuations” in bond markets around the world, says Christopher Baker, whose C.P. Baker & Co. in Boston manages a small hedge fund. The Federal Reserve “was aware that people were drunk with this stuff.”

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Indeed, while the hedge funds have been blamed for sparking the dramatic selloffs in bond and stock markets since the Fed’s rate hike, many other investors--including many mutual funds--in retrospect had made far larger bets than they should have on long-term bonds.

Just last fall, investors snapped up 100-year fixed-rate bonds from companies such as Walt Disney. The logic of being willing to accept a relatively low, fixed interest rate for the next 100 years, with all the unquantifiable economic risks in the interim, escaped many pros.

But some investors were so willing to believe the story that inflation was dead, and that long-term interest rates would continue to decline from what were already 20-year lows last fall, that the greater risk seemed to be in not buying bonds with the rest of the crowd.

At the same time, betting on further interest rate declines in the recession-wracked economies of Europe and Japan appeared to make perfect sense.

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In their defense, investors who loaded up on bonds can say that they did so fully expecting that the Fed would raise short-term interest rates eventually. In theory, by taking a preemptive strike against inflation, the Fed should have helped bring long-term yields down further, not push them up. That’s because long-term yields are supposed to respond to inflation expectations, not to the relative level of short-term rates.

*

It hasn’t worked out that way, of course--at least not so far. The yield on 30-year Treasury bonds has surged from a low of 5.79% last fall to 6.83% now as investors have bailed out. In Europe, bond yields have risen more than three-quarters of a point just since year’s end, also amid wild selling.

Interest rates also have skyrocketed in emerging economies, even though there has been no change in the improving fundamentals of many of those economies. Ashwin Vasan, a portfolio manager at Oppenheimer Management in New York, calculates that Argentine fixed-rate bonds now yield 5.3 percentage points more than long-term U.S. bonds, compared to about 3 percentage points more a month ago.

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And formerly red-hot global stock markets have tumbled as bond yields have jumped. Hong Kong’s Hang Seng stock index has plunged from 12,599.23 early this year to 9,802.03 now, a drop of 22%. In the United States, the Dow industrials have slid nearly 4%, virtually all of that drop occurring since the Fed’s move Feb. 4.

In effect, even if the Fed didn’t want to prick the global markets bubble, it now has, and perhaps with more dislocation in the world’s financial system than the central bank, or anyone else, might have expected. It’s not helping, either, that America and Japan are waltzing toward a trade war, further chilling the mood of some investors.

“I think they (the Fed) wanted to slow down the speculation,” says David Hale, economist at Kemper Securities in Chicago. “But I don’t think they wanted to see a 1-percentage-point rise in long-term interest rates.”

Which raises a disturbing question: With the bubble burst, and investors of all stripes suddenly looking for reasons to sell, has the Fed set off a chain reaction of market declines worldwide that will go much farther than logic would dictate?

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Two aspects of the stock and bond markets turmoil give some veterans pause today:

* First, one of the selling points for international diversification over the past year was that world markets generally don’t correlate--that is, Americans should invest overseas because those markets often rise when the U.S. market falls.

So far this year, virtually all stock and bond markets on the globe are slumping in value. That could cause individual investors to reconsider the wisdom of sending so much money overseas, the hot trend since last summer.

* Second, a major reason U.S. bond yields continue to rise is simply because the majority of investors have succumbed to the “deer-in-the-headlights” syndrome--they’re so stunned by what has occurred in such a short time, they’re afraid to step up and buy, for fear of being buried under another avalanche of bond dumping by hedge funds and other desperate sellers.

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Rates can’t rise forever, of course. Some bond pros now say foreign bonds in particular are screaming buys. But in the mammoth U.S. bond market, there is no sign yet that enough investors are willing to bet that the process of wringing out speculation has fully run its course.

The Jump in Yields

How U.S. bond yields have risen since the end of the year, as measured by Merrill Lynch indexes.

Avg. annualized yield: Bond type 12/31/93 Now U.S. Treasury (1- to 10-year) 4.75% 5.37% U.S. Treasury (10- to 30-year) 6.56% 6.99% High-quality corporate 5.83% 6.35% (1- to 10-year) High-quality corporate 7.22% 7.54% (10- to 30-year) Junk corporate 9.62% 9.56% GNMA 6.70% 7.30% Muni general oblig. (10-year) 4.85% 4.95% Muni general oblig. (20-year) 5.55% 5.60%

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Source: Merrill Lynch & Co.

Trying Times on Wall Street The current tailspin in the world’s stock and bond markets--triggered in part by the Federal Reserve’s raising of short-term interest rates on Feb. 4--has drawn attention to key policy makers, market players and trading strategies that may have contributed to the down-spiral.

KEY PLAYERS

Alan Greenspan: The move by the U.S. Federal Reserve chairman on Feb. 4 to raise the so-called federal funds rate is widely seen as signaling the end of a period of falling U.S. interest rates and triggering the current market sell-offs.

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Banks and securities houses: Big “money-center” banks such as Bankers Trust and J.P. Morgan that had loaned money to hedge funds also were trading on their own, and are said to have suffered huge losses. Big securities firms such as Goldman Sachs and Morgan Stanley also have had huge trading positions. To cut their losses, these traders may have unloaded more of their securities, thus contributing to the downslide. Hedge funds: These multibillion-dollar private investment groups made huge bets early this year that U.S., Japanese and European bond yields would continue to drop and the Japanese yen would weaken against the dollar. But those bets have proved ill-timed, leading to billions of losses and heightening market volatility. Because they often borrow most of their money and invest in derivatives, such as futures and options, the funds are highly leveraged and must sell huge amounts quickly to protect their positions.

Big speculators: George Soros is perhaps the world’s best known international market speculator and hedge fund operator. His trading operation is said to have lost $600 million in recent weeks. But two years ago he reportedly made $2 billion betting against the British pound. Michael Steinhardt, another prominent speculator, is said to have lost hundreds of millions of dollars in recent weeks.

WHAT TO WATCH

Yields: Yields on U.S. Treasury securities have risen sharply since Feb. 4., discouraging cuts in foreign bond yields that hedge funds had been betting on. Further gains in yields could snuff out the U.S. recovery and lead to further sell-offs in stocks. Growth: If the economy continues to grow fast--the 4th quarter of 1993 saw expansion at an 7.5% rate and many analysts expect 3.6% growth this year--fear of inflation will obligate the Fed d to tighten further by increasing short-term interest rates. That would lead to higher rates for some mortgages, bank CDs and other loans and investments. The markets respond best to slow, steady growth with minimal inflation.

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DOW JONES INDUSTRIAL AVERAGE Daily close since Jan. 3:

Thursday: 3,824.42

30-YEAR TREASURY BOND YIELDS Thursday: 6.83


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