[Mb-civic] Buttonwood The parable of the cats Economist

Wed Oct 27 09:43:42 PDT 2004

Buttonwood 

The parable of the cats

Oct 26th 2004 
>From The Economist Global Agenda

The financial markets are fretting about a record oil price, the prospect of
slower growth, a wobbly dollar and much more

BUTTONWOOD¹S cats are normally the very picture of somnolent peacefulness.
Last night, however, the purrs turned into deep growls, and the growls, all
of a sudden, into a whirr of fur and fury. Listen carefully and you can hear
the growls from financial markets too. Can the fur and fury be far off?

The growls come in many forms. The first and most obvious is the rising
price of oil. The US benchmark, light, sweet crude‹it sounds a bit like the
stuff you have with a burger, doesn¹t it?‹rose this week to over $55, a new
record, at least in nominal terms. Oil for future delivery has also been
rising, suggesting that not only do consumers think it very unlikely the
price of oil will fall sharply but that it may indeed rise further. The
price of petrol and other oil derivatives is also going up, in part because
the price of crude is rising, but also because there isn¹t enough refining
capacity. That these increases will have a bad effect on the world economy
is not in doubt; the questions are what sort of bad effect and how big.

The bad effects come in two varieties: inflation and slower growth. Having
worried briefly about the first of these earlier in the year, financial
markets are becoming more vexed about the second, especially since central
banks, and the Federal Reserve in particular, have been removing some of the
extreme looseness of monetary policy in recent months by hiking interest
rates, albeit by tiny amounts. Thus have inflation expectations dropped. The
combination of lower expected inflation and slower growth has caused the
yield on ten-year Treasuries to fall by almost a percentage point since
reaching a high earlier this year. Not that this is solely an American
concern. An index of rich-country government bonds compiled by Citigroup has
gone up by an extraordinary 10% since May.

Worries about the effects of slower growth and higher oil prices on
corporate profits have started to spook stockmarkets. The Eurotop 300 index
of European shares is now down by some 4.5% from its high this year;
America¹s S&P 500 is down around 5.5%; and Japan¹s Topix has fallen by
almost 12%. Given how expensive these markets are by any reasonable metric,
however, these falls can be seen as slight.

 Growls aplenty there are elsewhere, too. The cost of insuring against bad
outcomes in equity markets, at least as measured by the Chicago Board
Options Exchange¹s VIX index of volatility, has been rising in recent days.
It is, however, still extraordinarily low‹a third of its level in October
2002‹given the myriad uncertainties in the world.

So, too, are the interest rates demanded by holders of corporate bonds over
those on Treasuries, even though these spreads have climbed a bit over the
past couple of weeks. In America, spreads of bonds rated BBB are about 1.2
percentage points, four points less than they yielded in October 2002. Most
of the doubts about creditworthiness have centred on car companies and, of
late (thank you, Mr Spitzer), on insurers. For how long will concerns be so
narrow, and rewards so meagre, if growth really falters?

Spreads on junk bonds have actually fallen lately. They now yield about four
percentage points or so over Treasuries. In October 2002 the spread was over
ten points, not that the numbers meant much, given the panic in the markets
at that time. Perhaps all the issuers of such bonds are indeed much
healthier now than they were then. Perhaps, on the other hand, they are
simply the beneficiaries of ultra-loose monetary policy and a huge appetite
for risk among investors. After a panic in May, emerging-market debt
recouped most of its losses. In recent days this market, too, has wobbled
but it still looks horribly expensive by historical standards.

The dollar has also been falling out of favour in recent days. This week, it
reached its lowest level in eight months on a trade-weighted basis,
according to the Fed, and is within a whisker of an all-time low against the
euro. Foreign-exchange traders seem to have discovered what everyone else
already knew: that America¹s huge and growing current-account deficit is
unsustainable, and that two things are required to correct it. First,
Americans must save more (which will slow growth, perhaps sharply); and
second, the dollar needs to fall more than it has done already‹perhaps a lot
more.

 Alan Greenspan, the Fed¹s chairman, and a man with a somewhat Panglossian
view of the world, thinks that all these fears are overdone. His message is:
don¹t fret about America¹s current-account deficit, consumers¹ huge debts or
the surging oil price; none of them matters, or at least not much. But your
columnist does worry about such things, not least because the financial
markets seem to be frighteningly sanguine about them: fears in the markets
look about as overdone as a steak haché.

 The dollar looks in danger of plunging, the price of oil continues to
surge, gold is going up and world growth is slowing. Oh, and America is
about to hold an election that could create as much uncertainty as it
removes. Small wonder that there are a few growls from financial markets.
Buttonwood has a nasty feeling that something worse is in store.

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