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TURMOIL IN THE MARKETS : Did Fed Play Its Hole Card?

March 04, 1994|TOM PETRUNO

Trying to explain the extraordinary upheaval in global financial markets over the past month, some Wall Streeters are posing an intriguing question:

Were world stock and bond markets riding atop a dangerous speculative bubble before this--and did the Federal Reserve Board understand this and vote to willfully prick that bubble?

On the surface, the Fed's decision to boost short-term interest rates by a quarter-point on Feb. 4, the first such credit tightening in five years, was a function of the U.S. economy's robust growth. The Fed wanted to preempt the rising inflation that often follows economic booms.

But at the same time, the central bank was obviously aware of the unprecedented flow of dollars plowing into foreign stocks and bonds over the past six months, driving share prices up 50% to 100% and bond yields way down.

Much of that money, from both professional "hedge funds" run by heavily leveraged global traders and from mutual funds flush with dollars from average Americans, was increasingly being targeted at extremely high-risk emerging markets, from Southeast Asia to Latin America to Africa.

Moreover, the Fed and other global central bankers have been quite vocal about their concern over the mushrooming use of often-shadowy derivative securities worldwide.

Derivatives, which include options, futures and a host of related "synthetic" securities, allow traders to make bets on stocks and bonds with little money down, or to hedge themselves against market declines and thus maintain bigger positions in stocks and bonds than they otherwise might.

If Fed Chairman Alan Greenspan wanted to send a signal that would prompt big investors to tone down their level of speculation in red-hot markets around the world, including in the United States, nothing would be more effective than a move to tighten credit.

Higher U.S. interest rates, after all, immediately boost the cost of leverage--the billions in borrowed bank dollars used by hedge funds and others to magnify their market bets.

At the same time, higher U.S. rates would be expected to stem at least some of the tremendous dollar flow to overseas markets, by making U.S. money market instruments and bonds more attractive. If the Fed were concerned about keeping the U.S. economy's recovery on track, one key would be to avoid sudden artificial shortages, including shortages of capital.

Did the Fed believe a bubble was forming in financial markets? Greenspan hasn't said so publicly, but perhaps he didn't have to.

"Everybody knows we've been pushing the envelope with valuations" in bond markets around the world, says Christopher Baker, whose C.P. Baker & Co. in Boston manages a small hedge fund. The Federal Reserve "was aware that people were drunk with this stuff."

Indeed, while the hedge funds have been blamed for sparking the dramatic selloffs in bond and stock markets since the Fed's rate hike, many other investors--including many mutual funds--in retrospect had made far larger bets than they should have on long-term bonds.

Just last fall, investors snapped up 100-year fixed-rate bonds from companies such as Walt Disney. The logic of being willing to accept a relatively low, fixed interest rate for the next 100 years, with all the unquantifiable economic risks in the interim, escaped many pros.

But some investors were so willing to believe the story that inflation was dead, and that long-term interest rates would continue to decline from what were already 20-year lows last fall, that the greater risk seemed to be in not buying bonds with the rest of the crowd.

At the same time, betting on further interest rate declines in the recession-wracked economies of Europe and Japan appeared to make perfect sense.

In their defense, investors who loaded up on bonds can say that they did so fully expecting that the Fed would raise short-term interest rates eventually. In theory, by taking a preemptive strike against inflation, the Fed should have helped bring long-term yields down further, not push them up. That's because long-term yields are supposed to respond to inflation expectations, not to the relative level of short-term rates.


It hasn't worked out that way, of course--at least not so far. The yield on 30-year Treasury bonds has surged from a low of 5.79% last fall to 6.83% now as investors have bailed out. In Europe, bond yields have risen more than three-quarters of a point just since year's end, also amid wild selling.

Interest rates also have skyrocketed in emerging economies, even though there has been no change in the improving fundamentals of many of those economies. Ashwin Vasan, a portfolio manager at Oppenheimer Management in New York, calculates that Argentine fixed-rate bonds now yield 5.3 percentage points more than long-term U.S. bonds, compared to about 3 percentage points more a month ago.

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