Monday, March 21, 2005

Fasten your seatbelts...

WSJ: "When the Federal Reserve raises interest rates, as it is expected to continue doing tomorrow, trouble usually follows. In 1987, the stock market crashed. In 1994, Orange County went bankrupt and Mexico devalued its peso, ravaging its economy. In 2000, the Nasdaq Stock Market bubble burst.

For months after the latest Fed tightening cycle began in June, everything seemed fine: Treasury-bond yields declined, stocks rose and volatility throughout markets fell -- the opposite of what happened in 1994, the last time the Fed reversed a prolonged period of easy money.

But in mid-February Fed Chairman Alan Greenspan declared low bond yields a "conundrum" and warned about "complacency." Since then, bond yields have shot up, closing at 4.51% Friday, and stocks have wobbled. The Dow Jones Industrial Average shed 144.7 points or 1.3% last week to close at 10629.67.

Are markets due for some kind of crisis?

"It seems likely," concludes a report from ISI Group, a New York economic-research firm.

Even with an expected boost in the Fed's target for the federal-funds rate, charged on overnight loans between banks, to 2.75% from 2.5% tomorrow, rates would remain historically low. But whenever the Fed tightens, borrowing costs rise and the economy slows. "If a company or country is a weak link, that combination of higher interest rates and reduced economic activity just tips them over," says ISI economist Nancy Lazar."

Let's see: leveraged carry-trade funds could blow up, the housing bubble could burst, equities could finally drop back to their historical P/E levels and corporate bonds could tank (the current spread vs treasuries is very low). On the other hand, higher rates are healthy for the dollar. I'd like to see the Fed funds rate above 4%, as I think the inflation rate is probably 3% right now.

2 comments:

Sir GreenSPan Con-UN-Drum said...

There can be only ONE valid long-term answer to
Chairman Alan Greenspan Conundrum:
The Activating Message for X-it & Security.
Warning:
Chairman Alan Greenspan is the official political hack of The Partners of the X-it in Washington.

Anonymous said...

This is the calmest Fed tightening cycle I know of, at least this far.

There is often a run up in the Japanese stock market this time of year, just in time for end of the fiscal year on March 31. Just as often the run up ends not long after. The reason may be to offer support for financial institutions which have to meet asset requirements. Curious.

Anne

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