A time for wizardry
John Plender, FT, August 21 1999

The great American public still has the spending bit between its teeth. That much is clear from the surge in imports that made such a signal contribution to this week's awful US trade figures.

And, with the shocking exception of the day trader in Atlanta who reacted to a market blip by going on a murderous shooting spree last month, Americans have yet to lose confidence in equities.

Compare and contrast with the state of confidence among market professionals. There, the mood remains nervous. The US, according to one seasoned equity fund manager, is the country of the fully invested professional bear.

Bonds are different, but also a source of gloom. Not the death of inflation has been the story of the summer, with long-dated Treasuries yielding over 6 per cent. This apparent end to the disinflationary bond bull market has been marked by financial distress. Banks and hedge funds that punted on a sloping yield curve earlier this year - that is, a market in which short-term interest rates remain well below long rates - have been caught as short-term rates have risen and the curve has flattened.

The carrying cost of their trades turned expensive suddenly in July. Many have been forced to close positions at a large capital loss. Forced sales explain many of the summer's seemingly arbitrary fluctuations in individual bond prices.

Then there were the "convergence" plays that failed to converge. For example, those who gambled on UK long gilts converging with euro-zone long bonds have been hit by the refusal of long gilts' yields to rise to euro-zone levels.

Symptoms of financial distress have been most apparent in the interest rate swaps market where banks and companies exchange fixed interest income streams for floating ones. Spreads there widened earlier this month beyond their level at the time of the bail-out of the Long-Term Capital Management hedge fund last August.

And it emerged this week that Goldman Sachs had lost $100m on its trading in derivative instruments such as swaps and swaptions. Many others who gambled on last August's extreme volatility not repeating itself will also have lost money.

Just to round off the picture, General American, a big Missouri-based insurer, has fallen victim to a liquidity crisis. Other insurers are smarting from the rise in bond yields and consequent fall in the value of their bond portfolios.

In currencies, meantime, professional investors have turned twitchy on what the US financial commentator James Grant calls the greatest brand name in global finance: the dollar.

Until now, an appreciating dollar has provided a benign mechanism for rebalancing the world economy after the Asian crisis. The rest of the world has pulled itself out of trouble by exporting to the US, while a strong currency has curbed US inflation.

For this, we all owe a debt to the great American public. But, unfortunately, the rebalancing process is not going to plan, partly because the US public has gone deeper into debt. By spending beyond their incomes on tick, Americans have contributed to this week's dismal trade data.

The inescapable message is that the US is suffering from excess demand. The deteriorating balance of payments provides only a temporary safety valve against inflation, as demand is satisfied from foreign supply.

Whatever happens when the Federal Reserve's open market committee meets next week, the trade data raise the possibility that it will take stronger medicine to slow the US economy than the markets now assume. The risk is that a monetary policy tough enough to curb excess US demand might be too tough to permit less than robust recoveries in Europe and Japan to gain strength.

How far, then, is the inflation scare in the bond markets justified? From a global point of view, a return to old-style inflationary boom and bust seems unlikely. We appear to have shifted to long economic cycles in which the upturn is driven by investment and the downturn is prompted by overcapacity.

Inflation still can arise from poor monetary management at country level: look at Russia. But deflation is as great a threat if an investment upsurge leads to an excessive overhang of debt.

In the present unsychronised economic upturn, overcapacity developed early in Asia. The US consumer has helped to ease the pain by absorbing much of the resulting excess supply of goods. But the US itself is now in the grip of an investment boom. And the Fed faces a very difficult monetary policy challenge.

Poor judgment could lead to inflation in the US, which might be followed by deflation if the boom goes on too long and too much debt piles up. Good judgment would require fine tuning to curb excess demand without precipitating a stock market plunge that would shrink the wealth of the American public and inflict a hard landing on the economy.

This will require deft psychological management of both main street and Wall Street. The spirits of the public must be damped down, but not to the point where they sabotage equities. The twitchy financiers need to be cheered up enough to prevent a dollar collapse that imposes too abrupt an adjustment on the balance of payments.

Over the past week, the markets have signalled a modest retreat from professional panic, which is good. But, to avoid a hard landing, too much rides, once again, on the fabled wizardry of Fed chairman Alan Greenspan. Who but a wizard could engineer a soft landing now?

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