A Greenspan Tactic Buoys the Bond Market

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

FLOYD NORRIS
A Greenspan Tactic Buoys the Bond Market

ALAN GREENSPAN has done it again. He has played the markets like a
virtuoso musician.

Mr. Greenspan's reputation in the long run will rest on whether he can
get the economy moving again. If not, he will be remembered for the
hubris he showed during the bubble, when he assured worriers that there
was no need for the Federal Reserve to deal with the inflating stock
market because he knew how to deal with bubble aftermaths and prevent
lasting economic damage.
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He has reason to worry. The bubble's economic impact has lasted far
longer than anyone expected, despite Dr. Greenspan's diet of Fed rate
cuts, which has cut short-term rates to 40-year lows. There are
indications that capital spending in the technology sector has finally
hit bottom, but an early upturn is no sure thing.

For months, Fed officials have been saying they were in no danger of
running out of ammunition. The Fed could buy longer-term Treasuries,
they said, even if it had not done so for decades.

Until this week, the markets seemed to view such talk as an academic
exercise of little interest to traders. But the Fed's statement when it
left rates unchanged on Tuesday decoupled the issues of economic growth
and inflation, and reassured investors that rates will stay low even if
the economy does better. "They basically made clear they are not
tightening for a long time," said William C. Dudley, chief United States
economist at Goldman, Sachs.

The impact on expectations was drastic, and can be seen in the
eurodollar futures market. That market lets you bet on where short-term
interest rates will be in the future. And traders are now betting that
rates will rise far more slowly than they had expected. The market
expectation for short-term rates in June 2006 is now 3.695 percent, down
half a percentage point since the Fed acted.

By giving a boost to the bond market while not alarming stock traders,
Mr. Greenspan pulled off a neat trick, even if expectations of sustained
low interest rates also hurt the dollar.

It is the currency markets that may provide the most interesting tales
of intrigue over the next year if world economic growth does not
accelerate. As it is, nearly every country has reason to hope for a
weakening currency, to help its exports compete.

Consider the dollar. Its strength in recent years has come because
foreigners were eager to invest here, and thus redeploy the dollars they
got as we ran huge trade deficits. It stands to reason that if American
investments seem less attractive, foreigners will invest less and the
dollar will decline.

But some central banks, notably in Asia, have no intention of allowing
that to happen. "China likes the current system," Mr. Dudley said. "It
allows them to keep their currency undervalued and people employed. It
is part of a policy of political stability in China." The central bank
in China has been buying dollars at a rapid pace to keep the Chinese
currency from rising against the dollar.

Only the Europeans seem oblivious to what is happening. Even as the
leading European economies teeter near recession, the European Central
Bank is reluctant to lower its interest rates.

That helps the euro, but Europe does not need such help. Robert J.
Barbera, the chief economist of ITG/Hoenig, points out that the latest
data, for March, indicated that the dollar price of American imports
from Europe had risen 6.5 percent over the previous year, while the euro
was up 25 percent against the dollar. The difference is shrinking
margins for European exporters.

A weak world economy means that everyone is fighting for shares of a
too-small pie. The hope is for a growing pie. That is why the Fed's
indication that it will not tighten for a long time is welcome, and why
lower European interest rates are overdue.