Fed Cut Sends Many Signals

By TOM PETRUNO

Oct. 16, 1998 12 AM PT

TIMES STAFF WRITER

Wall Street’s big rally Thursday on the heels of the Federal Reserve Board’s surprise interest rate cut must have been exactly what Chairman Alan Greenspan was hoping to see. Because a little “irrational exuberance” over stocks and bonds would feel a lot better to the central bank right now than investors’ current severe aversion to risk.

The Fed’s decision to cut its benchmark short-term interest rate, the federal funds rate, to 5% from 5.25%--following a similar cut Sept. 29--sent Treasury bond yields down sharply and powered the Dow Jones industrial average to a gain of 330.58 points, or 4.2%, to 8,299.36.

The markets didn’t appear to pause to ask the question that a lot of investment strategists were asking. As Stanley Nabi, investment policy chief at Wood Struthers & Winthrop, put it Thursday: Is the Fed, in cutting rates twice in three weeks amid wild global market turmoil, suggesting that “maybe there are [financial system] problems far in excess of what we know about?”

Other analysts said that, even though shell-shocked investors fear more near-term financial bombs, the Fed’s move is a powerful signal that it will do whatever it takes to keep the U.S. and global financial systems from falling into a hole from which there’s no escape--the market crash/deflation/depression scenario that has been increasingly dominating headlines worldwide.

“The message they want to deliver is, ‘We are awake and alert,’ ” said Larry Kreicher, economist and head of bond research at Alliance Capital Management in New York.

But within that broad message, the Fed is sending many individual messages to individual constituencies, experts say. Here are some of them:

* “It’s OK to buy higher-risk bonds again.” The gravest crisis in recent weeks hasn’t been in the stock market--it has been in the credit markets, where investors en masse have become reluctant to buy any bonds that carry even a hint of risk. That could shut down the economy by leaving needy corporate and government borrowers high and dry.

“It’s the credit market that is the big problem now,” said Stephen Slifer, economist at Lehman Government Securities in New York.

The Fed wants to stop bond investors’ rush from risk. It wants investors to feel confident that they can return to markets such as high-yield junk corporate bonds and emerging-market bonds. Without actually saying it, Greenspan is saying: “We’re going to supply liquidity to the system, and we’re going to keep the U.S. economy out of recession in 1999 and thus avert a slew of bond defaults.”

* “We’re the world’s central banker now--not just America’s.” The Fed would never say so out loud, of course. But its interest rate cuts are aimed as much at stabilizing severely traumatized foreign markets and economies as propping up the U.S. financial system.

Latin American stock markets understood that full well Thursday: The Mexican market soared 6.5%; the Brazilian market jumped 6.7%.

By cutting rates--and implying that there’s more to come--”the Fed is speeding up the flow of dollars worldwide,” said Gordon Richards, economist at the National Assn. of Manufacturers.

That happens two ways: By making U.S. interest rates less appealing to investors, the Fed encourages them to seek better returns abroad. And by stoking the U.S. economy, the Fed is hoping that Americans buy more foreign goods, thereby putting dollars in those goods-producers’ hands.

* “We don’t care about the dollar’s value.” The dollar on Thursday quickly sank from 1.631 German marks before the cut to 1.613 afterward--lowest since early-1997. It also fell against the yen.

Lower U.S. rates mean foreigners may feel less compelled to buy U.S. bonds and other assets, and that could mean the dollar’s value will fall further relative to other currencies.

If the dollar is a casualty of the Fed’s drive to bolster the markets and the global economy, so be it, the central bank seems to be saying. The good news is that America is just about the only country that can pursue monetary policy which, in the short run, is harmful to its currency.

That’s because the dollar is still the reserve currency of the world, and the U.S. economy is still largely dependent on itself. The dollar’s swings have effects, but domestically they aren’t overwhelming. Americans can live with a devalued dollar.

A secondary message here: The Fed wants Europe’s central banks--particularly Germany’s--to stop stalling and cut interest rates aggressively.

* “Irrational exuberance in the stock market is welcome again.” Two years ago, Greenspan worried that investors were getting carried away with stocks’ bull market. He continued to worry about that right into summer.

No more. With stocks down sharply, the Fed can argue that much of the “excess” in the bull market has been corrected. Moreover, the last thing the Fed needs is for stock-owning U.S. consumers to suddenly stop spending money because their portfolios have gone down in value. That could ensure a U.S. recession in 1999.

Some analysts on Thursday proclaimed that, with the Fed clearly intent on buffering the financial system via lower rates, investors will look past weak corporate profits and send the market sharply higher again in coming months.

“We see the Dow over 10,000 in the next nine months,” said Price Headley, investment strategist at Schaeffer’s Investment Research in Cincinnati.

Many other experts don’t buy it. Scott Grannis, economist at Western Asset Management in Pasadena, noted that despite Thursday’s rally, the Standard & Poor’s 500-stock index is just back to where it was Sept. 29--when the Fed made its initial rate cut.

From the stock market’s point of view, “We’ve got a lot of problems still to work out,” Grannis said--not only weaker earnings near-term, but the likelihood that, despite the Fed’s push on rates, the U.S. economy seems certain to slow in 1999.

Technically, the stock market also faces a potential barrage of year-end tax-loss-related selling, and the probability that, with a weaker dollar, foreign money isn’t going to be coming here to bolster our share prices.

* MAIN STORY: The Fed announces surprise rate cut. A1

* MARKETS SOAR: U.S. stocks zoom; Asian markets leap today. C4

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

A Gift to Wall Street

The Federal Reserve Board’s surprise interest rate cut Thursday drove bond yields lower and stocks sharply higher, but also undercut the dollar’s value. How Markets reacted:

Bond yields dive ...

Rates on U.S. Treasury securities

6-mo.

Wed.: 4.20%

Thu.: 3.94%

2-yr.

Wed.: 4.11%

Thu.: 3.83%

10-yr.

Wed.: 4.61%

Thu.: 4.41%

...as does the dollar ...