NEWS ANALYSIS : Turbulent Markets Seen Masking Healthy Economy
Talk about the mysteries of finance. Strange as it is for most folks to understand, the strengthening U.S. economy is being blamed for the unsettling drop in stock and bond prices as interest rates have risen dramatically in recent weeks.
Each day’s good economic news seems to rattle the financial markets--and Thursday was no exception. Government reports that unemployment claims fell while factory orders rose were cited by analysts to explain further declines in the value of bonds and stocks.
What is going on? Are we at a turning point, as some analysts believe, where fears of inflation and a fragile global financial system are about to send the markets--and the economy--into a long decline?
No, say the great majority of economic and financial experts. The markets, as they usually do, are reacting to fears that economic expansion will bring increased inflation and rising interest rates.
But this time market fears appear to be overblown. What is really happening is that the U.S. economy is expanding in a very healthy way, with rising productivity and without more inflation.
And that healthy expansion could continue for some years, according to Federal Reserve Chairman Alan Greenspan, who surprised analysts a month ago when he raised short-term interest rates. The markets reaction to that move has been extraordinary, but analysts now believe that Greenspan’s purpose may not have been the usual inflation-fighting action but part of a strategy to deflate the threat of an international speculative bubble.
The activities of major global investors, swinging massive amounts of borrowed capital in international securities and currency markets, threatened to become a destabilizing force. These so-called “hedge funds” made huge bets early this year that interest rates on Japanese and European bonds would continue to drop and that the Japanese yen would weaken. But their investments, more than $300 billion by some estimates, distorted bond markets in Europe and Japan.
To counter this potentially dangerous speculation, according to a growing consensus among financial professionals, Greenspan raised U.S. rates, thus affecting European and Japanese markets. This caused the hedge fund bets to go wrong, with billions of dollars in losses. The resultant sell-offs of their holdings have contributed to market gyrations, many traders say.
That explains the violent reaction in U.S. stock and bond markets to Greenspan’s small quarter-point hike in U.S. interest rates, to 3.25% from 3%. Since Feb. 4, nervous traders have driven up the rate on the U.S. Treasury’s 30-year bond, the instrument that influences most mortgages and business and consumer borrowing, to 6.83% from 6.3%. In the super-sensitive world of the financial markets, that’s a dramatic rise, “one of the fastest in 40 years,” according to John Isaacson, research director of Payden & Rygel, a Los Angeles investment firm specializing in fixed income securities.
But with ordinary home mortgages and mutual funds being affected by distant events, investors are worried. Many wonder whether this is a rerun of 1973 when a quadrupling in the price of oil sparked raging inflation and sent stocks into a long decline. Or is it 1987 all over again, when the markets crashed amid mounting trade tension and an overheating economy?
This time is not at all like those earlier periods. The U.S. economy and financial markets are not on the brink of a long decline. On the contrary, the economy has turned from its long recovery from the recession of 1990-91 into an expansion. Economists now predict 3.6% growth this year, or an additional $216 billion worth of economic activity. California may not join fully in such growth until early next year, although a better national economy could quicken the pace here.
That kind of economic growth creates jobs, and in fact most predictions are that this morning’s unemployment report will be favorable. Yet increased inflation is not seen as a real threat because productivity, up more than 4% last year, is growing across the board. Both in manufacturing and services industries, U.S. business is getting more output per dollar of investment or hour of labor these days. And that means low or decreasing inflation.
Today, change is in the air, not decline. The economies of Europe and Asia are adjusting to the post-Cold War period, as the U.S. economy has been doing since 1990. Though the effort to change Japan’s has led to a very public dispute, it is not likely to upset an increasingly interdependent and growing world economy.
The contrast with earlier periods of economic change and market volatility is dramatic. In 1973, the start of a bear market saw a quadrupling in the price of oil and the instability of Watergate in the U.S. government.
In 1980, then Federal Reserve Chairman Paul A. Volcker was forced to bail out U.S. and international banks that had become overextended in the inflation-driven speculations in silver, oil and other commodities. He also had to take stern action, and trigger a recession, to break the back of double-digit inflation.
Greenspan, who acted quickly to curb the market slide in 1987, may have made a timely move again. He stepped in to curb hedge fund speculation before banks and markets were truly threatened. Some financial professionals disagreed with his action, saying in effect that the normal workings of markets would have resolved difficulties.
But markets typically go to extremes before speculation is reversed, in a resounding crash with the collapse of brokerage houses and threatened failures of banks. It is when bank failure is threatened that economies are truly disrupted. As with Volcker in 1980, the Federal Reserve has to step in with emergency funds, distorting and inflating the economy.
No crash seemed imminent in the current situation, but there was a halt in trading Wednesday in the stock of Bankers Trust New York, one of the leading dealers in interest rates swaps and other mechanisms of what are called financial derivatives, so that reports of trouble could be dispelled.
Still, even the fact that the economy could be threatened by excesses of hedge funds and deal making in obscure financial instruments like interest rate swaps, will strike most people as inexplicable. If hedge funds are a threat, why are they allowed at all?
The answer is that hedge funds are just a part of a new and still-emerging global financial system in which more than $1 trillion of securities, currencies and all manner of financial instruments are traded every day, with benefits for all. “The trading is maximizing the efficiency of capital movements, bringing together money that is available in one spot but required in another,” says Dennis Weatherstone, chairman of J.P. Morgan & Co.
For example, financing for the development of countries like Mexico, China and Indonesia is possible because this immense financial market allows risk to be spread, Weatherstone and others explain.
Risk is spread, typically, by swapping--reducing the risk of a long-term loan to finance a factory in China, say, by trading it for a security that has a floating rate of interest. Trading it to whom? Perhaps to one of the hedge funds, which would accept the risk of long-term interest as part of its “bet” on the general direction of rates.
The dangers in this new world of finance are evident in the example: What if the factory doesn’t get built on time, and its output is not then available to pay the loan? What if interest rates go against the direction bet on by the hedge fund?
“The consequence would be failure of the loan or bankruptcy of the hedge fund,” says Patricia Klink, president of Advisers Capital Management, a New York-based investment firm.
That’s acceptable so long as the bankruptcies don’t get too large and their consequences don’t spread too far. One reason for the volatility in stock and bond markets today is that Fed Chairman Greenspan stepped in to prevent things from going too far.
As the dramatic effects of his action play out, ordinary investors and mortgage holders are advised to keep an eye on the underlying strength of the U.S. economy and not be diverted by the froth on the top.
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