Back to the Future—in 1987?
June 10, 2008
By RANDALL W. FORSYTH
The history of 21 years ago may not repeat, but there seem to be a few rhymes
THE DOLLAR IS WEAK AND falling. Inflation pressures are building. European central banks are growing restive and suggesting interest-rate hikes are in order. In the U.S., however, the concerns about the greenback and inflation are tempered by worries that tightening policies could throttle growth.
All this is taking place against a backdrop of regulators looking at ways to curb speculation and deal with a burgeoning of new financial instruments that are supposed to promote safety but pose greater risks.
The year was 1987. And if it appears to bear a certain resemblance to the present, you'd be half right. The economy was strong then and would continue to grow for a couple more years. Now, the argument of whether the U.S. economy in recession is a matter more of semantics than economics after five straight monthly declines in employment.
In case you needed to be reminded, on Black Monday, Oct. 19, 1987, the Dow Jones Industrial Average plummeted 508 points. That doesn't sound so daunting given that investors' have become inured to wrenching, one-day moves such as Friday's 395-point slide. But 21 years ago, that 508-point plunge took a record 22.6% off the blue-chip average, which would be all but impossible to equal given the rules and circuit-breakers put in place in the wake of Black Monday.
But what is frightening now is the escalation of rhetoric and expectations over interest rates on both sides of the Atlantic, a key in the series of events that led up to Black Monday.
Last week, European Central Bank President Jean-Claude Trichet suggested an increase in its key policy rate next month is "possible." And Monday, Trichet underlined the message, saying it "was entirely inspired by this necessity to anchor inflation expectations."
The ECB president's warning last week followed comments by Federal Reserve Chairman Ben Bernanke, who expressed concern that the weakness in the dollar could be feeding inflation expectations. That was extraordinary because the dollar's value is the purview of the Treasury, not the Fed, and the central bank habitually avoids comments on the currency.
On Monday, however, it was clear the Treasury and the Fed were actually were on the same page as Secretary Henry Paulson uttered the "I" word --intervention. "I would never take intervention off the table or any policy tool off the table," he said in an interview with CNBC.
The U.S. hasn't intervened in the currency markets since the Bush Administration took over in 2001. That's what makes the mention significant. Markets that figured selling the dollar was a one-way bet now have to be on their guard, even if odds of actual intervention remain very long.
Intervention alone can't affect exchange rates except over the short term. It has to be backed up with complementary changes in monetary policy, with weak-currency nations tightening and strong-currency nations easing.
The outlook for central-bank policies has shifted radically, to increases from cuts, because of concerns about worsening inflation -- even in the teeth of weakening growth, rising unemployment and the unwinding of arguably the greatest bubble ever.
In the U.S., the November federal-funds futures contract now fully prices in a quarter-point increase in the key policy rate at the Oct. 28-29 meeting of the Federal Open Market Committee. A further quarter-point hike in the funds rate at the Dec. 16 FOMC meeting is nearly discounted by the January 2009 futures contract. Moreover, the futures market even priced in two additional quarter-point hikes by next May -- just in Monday's trading.
That marks a huge reversal in expectations for Fed policy, which had been thought to be on hold after the April 29-30 FOMC meeting, when it cut the fed-funds target to the current 2%. Minutes of the confab showed the decision was a "close call," with two dissents in favor of no reduction out of concern about inflation. But the notion of rate hikes was not evident.
Meanwhile, rate-hike expectations are becoming ingrained in Europe. As noted, the ECB is expected to move next month. And in the U.K., investors started to brace for the Bank of England to boost rates over the coming year, also a massive reversal in expectations, given the financial fallout from that nation's housing bust.
The short end of bond markets on both sides of the Atlantic sold off sharply, with the two-year Treasury note yield ratcheting up 33 basis points (about a third of a percentage point), a huge battering. There also were massive hits at the short end of U.K. gilts and German bunds, the benchmark of the European bond market.
The dollar firmed Monday following Treasury Secretary Paulson's comments but remains under pressure, in part because of expectations of ECB rate hikes. But such moves could backfire.
"The Trichet way to fight inflation is dumb because it is counterproductive," writes Ed Yardeni, the veteran Wall Street economist who heads an investment advisory bearing his name. "The ECB has the same inflation problem all other central banks are facing: Oil and food prices are soaring, partly because of the weak dollar. Bernanke's comments helped to strengthen the dollar and weaken commodity prices. Trichet's comments had the opposite effect, causing the dollar to sink and oil prices to soar."
The effects of skyrocketing oil, a weak dollar and contradictory interest-rate policies were apparent in Friday's market rout. The likelihood of the Fed raising interest rates when the unemployment rate is rising sharply -- even if it's only a statistical quirk -- historically have been slim and none.
In 1987, the Bundesbank insisted on raising interest rates despite the precariousness of currency markets. Back then, Washington was looking to crack down on corporate takeovers, which were deemed to be excessively speculative -- just as long-only commodity funds are being viewed with increasing suspicion by regulators. And, then as now, there was the explosion of derivatives -- stock-index futures and portfolio insurance in the 1980s, credit derivatives in this decade -- that have the potential to destabilize the financial system.
Those are perhaps superficial similarities. There are two distinct differences now. In 1987, the global economy was strong and oil was cheap. It really may be different this time, but not better.
Source : www.barrons.com
The history of 21 years ago may not repeat, but there seem to be a few rhymes
THE DOLLAR IS WEAK AND falling. Inflation pressures are building. European central banks are growing restive and suggesting interest-rate hikes are in order. In the U.S., however, the concerns about the greenback and inflation are tempered by worries that tightening policies could throttle growth.
All this is taking place against a backdrop of regulators looking at ways to curb speculation and deal with a burgeoning of new financial instruments that are supposed to promote safety but pose greater risks.
The year was 1987. And if it appears to bear a certain resemblance to the present, you'd be half right. The economy was strong then and would continue to grow for a couple more years. Now, the argument of whether the U.S. economy in recession is a matter more of semantics than economics after five straight monthly declines in employment.
In case you needed to be reminded, on Black Monday, Oct. 19, 1987, the Dow Jones Industrial Average plummeted 508 points. That doesn't sound so daunting given that investors' have become inured to wrenching, one-day moves such as Friday's 395-point slide. But 21 years ago, that 508-point plunge took a record 22.6% off the blue-chip average, which would be all but impossible to equal given the rules and circuit-breakers put in place in the wake of Black Monday.
But what is frightening now is the escalation of rhetoric and expectations over interest rates on both sides of the Atlantic, a key in the series of events that led up to Black Monday.
Last week, European Central Bank President Jean-Claude Trichet suggested an increase in its key policy rate next month is "possible." And Monday, Trichet underlined the message, saying it "was entirely inspired by this necessity to anchor inflation expectations."
The ECB president's warning last week followed comments by Federal Reserve Chairman Ben Bernanke, who expressed concern that the weakness in the dollar could be feeding inflation expectations. That was extraordinary because the dollar's value is the purview of the Treasury, not the Fed, and the central bank habitually avoids comments on the currency.
On Monday, however, it was clear the Treasury and the Fed were actually were on the same page as Secretary Henry Paulson uttered the "I" word --intervention. "I would never take intervention off the table or any policy tool off the table," he said in an interview with CNBC.
The U.S. hasn't intervened in the currency markets since the Bush Administration took over in 2001. That's what makes the mention significant. Markets that figured selling the dollar was a one-way bet now have to be on their guard, even if odds of actual intervention remain very long.
Intervention alone can't affect exchange rates except over the short term. It has to be backed up with complementary changes in monetary policy, with weak-currency nations tightening and strong-currency nations easing.
The outlook for central-bank policies has shifted radically, to increases from cuts, because of concerns about worsening inflation -- even in the teeth of weakening growth, rising unemployment and the unwinding of arguably the greatest bubble ever.
In the U.S., the November federal-funds futures contract now fully prices in a quarter-point increase in the key policy rate at the Oct. 28-29 meeting of the Federal Open Market Committee. A further quarter-point hike in the funds rate at the Dec. 16 FOMC meeting is nearly discounted by the January 2009 futures contract. Moreover, the futures market even priced in two additional quarter-point hikes by next May -- just in Monday's trading.
That marks a huge reversal in expectations for Fed policy, which had been thought to be on hold after the April 29-30 FOMC meeting, when it cut the fed-funds target to the current 2%. Minutes of the confab showed the decision was a "close call," with two dissents in favor of no reduction out of concern about inflation. But the notion of rate hikes was not evident.
Meanwhile, rate-hike expectations are becoming ingrained in Europe. As noted, the ECB is expected to move next month. And in the U.K., investors started to brace for the Bank of England to boost rates over the coming year, also a massive reversal in expectations, given the financial fallout from that nation's housing bust.
The short end of bond markets on both sides of the Atlantic sold off sharply, with the two-year Treasury note yield ratcheting up 33 basis points (about a third of a percentage point), a huge battering. There also were massive hits at the short end of U.K. gilts and German bunds, the benchmark of the European bond market.
The dollar firmed Monday following Treasury Secretary Paulson's comments but remains under pressure, in part because of expectations of ECB rate hikes. But such moves could backfire.
"The Trichet way to fight inflation is dumb because it is counterproductive," writes Ed Yardeni, the veteran Wall Street economist who heads an investment advisory bearing his name. "The ECB has the same inflation problem all other central banks are facing: Oil and food prices are soaring, partly because of the weak dollar. Bernanke's comments helped to strengthen the dollar and weaken commodity prices. Trichet's comments had the opposite effect, causing the dollar to sink and oil prices to soar."
The effects of skyrocketing oil, a weak dollar and contradictory interest-rate policies were apparent in Friday's market rout. The likelihood of the Fed raising interest rates when the unemployment rate is rising sharply -- even if it's only a statistical quirk -- historically have been slim and none.
In 1987, the Bundesbank insisted on raising interest rates despite the precariousness of currency markets. Back then, Washington was looking to crack down on corporate takeovers, which were deemed to be excessively speculative -- just as long-only commodity funds are being viewed with increasing suspicion by regulators. And, then as now, there was the explosion of derivatives -- stock-index futures and portfolio insurance in the 1980s, credit derivatives in this decade -- that have the potential to destabilize the financial system.
Those are perhaps superficial similarities. There are two distinct differences now. In 1987, the global economy was strong and oil was cheap. It really may be different this time, but not better.
Source : www.barrons.com
