Finance after the old rules

["Ian Murray" <seamus2001@xxxxxxxx>]

[FT]

< barry.riley@xxxxxx >

The Long View: Rules of engagement
By Barry Riley
Published: September 21 2001 15:37 | Last Updated: September 21 2001
16:02



Abruptly the rules in the financial markets have been changed. We had
become accustomed, during the 1990s, to the era of central banking
wisdom, in which paternalistic (and unelected) controllers of the
major currencies have imposed strict monetary controls and pursued low
inflation targets.

The European Central Bank was the last of these institutions to join
the regular circuit. In each country, or currency zone, lengthy
debates would be conducted by market participants on when the next
rise, or fall, of a quarter of a percentage point in short-term
interest rates might be imposed.

Now a partial state of war has been declared, and the priorities have
been drastically altered. Central banks are flooding their financial
markets with liquidity, regardless of the longer-term consequences.
There has been official intervention in many markets in currencies and
securities (and probably undeclared intervention in many more).

All this creates new risks, but may present some fresh opportunities.

There is an uncomfortable reminder of underlying instability. In
wartime the official inflation targets, or the detailed targets within
the European Stability and Growth Pact, will count for nothing.

We are by no means yet on a full war footing, but we have been made
aware that free and efficient markets are peacetime luxuries.

The financial tools of war include frozen or closed markets, the
direction of capital into approved channels, forced savings, and
eventually price and profit controls. There is still traded a British
Government bond called War Loan, on which patriotic investors have
lost heavily in real terms since it was first issued in 1917.

Investors are put under pressure to pursue national objectives, which
this week has meant that New York hedge funds were not supposed to
short US equities even though the reopened markets have tumbled and
the Dow Jones Average is down about 12 per cent this week.

Latent risks have suddenly become apparent in, for instance, the
airline and insurance industries. On US equities in general, the risk
premium (or the expected annual reward for accepting the higher risks
of equities) fell to only about 2 per cent by the peak of the 1990s
bull market.

That premium, depending on the precise assumptions in making the
calculation, has probably now risen to more than 4 per cent, as the
S&P 500 Index has tumbled by 33 per cent from its 2000 high; but the
risk premium was much higher (maybe 6 per cent or 7 per cent) in the
aftermath of the last really serious and prolonged bear market, in the
1970s.

Far Eastern governments have been supporting their stock markets, to
protect public confidence and the level of collateral supporting their
banking systems. There have been many rumours about the extent of
support, or at any rate of political pressure on institutions, in the
US. There is, perhaps, a decent case for trying to limit short-term
volatility and block off self-feeding downward spirals; but there is
no justification for fixing artificial floors that will inevitably
collapse before long.

What about currencies? One of the cheekiest of the week's official
statements came from the Japanese government, taking credit for
intervening to support the US dollar.

In fact it has been trying to patch up its own problems, as the
repatriation of the overseas investments of Japanese citizens has
pushed up the exchange rate of the yen to levels posing still more
competitive damage to Japan's slumping economy.

The terrorists have declared a fatwah against the US, but Japan is
arguably the most likely victim - because of collateral damage. So far
Japan has resisted the siren calls of foreign economists to choose
hyperinflation as the easiest route out of its debt trap. Now,
however, there is a new external menace conveniently available to be
blamed by Tokyo's politicians as the trigger for monetary destruction.

In the US and Europe the coming economic recession will suppress
inflation in the short run. We start from a year-on-year rise in
consumer prices of 3 per cent in the US and 2.3 per cent in the
eurozone. Awkwardly the underlying UK inflation rate jumped above its
2.5 per cent target this week, clashing with the Bank of England's
decision to cut its interest rate to 4.75 per cent, the lowest since
1964. There should not be a problem in the near term, unless oil
prices rise sharply higher. Anyway, the Bank of England, like the
other central banks, is encouraged to take its eye off this particular
ball.

Certainly it is hard to see significant inflation being generated by
the labour market, the housing market or commodities in present
circumstances. Looking two or three years ahead, however, the
inflationary consequences of military spending and a liquidity bonanza
could be more serious.

Bond investors, at any rate, are in a potentially vulnerable position.
This week Congress handed President Bush $40bn as just the first in a
possibly extended series of instalments, and the long Treasury bond
market began to count the possible cost, not just in terms of possible
inflation, but also in relation to the potentially heavy increase in
issuance. Long Treasuries could so easily swing from scarcity to glut.

So this week investors sought sanctuary at the short end of the yield
curve, although yields there are under 3 per cent.

The 30-year Treasury bond yield has climbed to 5.63 per cent, compared
to a low point of 5.25 per cent back in March.

Meanwhile, equities worldwide are searching for a bottom. But it is
hard to find a rational basis for valuation. Is there any point in
drawing up one-year or five-year forecasts of company earnings?

No doubt the swift capture of Osama bin Laden would trigger a big
stock market rally - we may wonder how much global market
capitalisation could rest on one man's head - but that would not
really be the end of the matter.

When confidence abounds, and projections can reasonably be made on the
basis of steady economic growth in the long term, a stake in the
future, through the equity market, is worth a great deal of money. But
uncertainty can destroy most of that. True, irrational pessimism is no
more justified than the irrational exuberance that was so prevalent
two years ago. All that remains is to get the timing right.

This has been a week to steer well clear.