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The Fed Is to Blame

A. Gary Shilling

The ills that the Federal Reserve is fighting are largely of its own making. Now that it finally is hiking rates, the effects could be brutal for a lot of people.

Pity the Fed. With its first quarter-point increase in late June, the central bank is trying to unwind years of leaping financial leverage and speculation without heavy casualties. Ironically, the problem is largely the Federal Reserve's own doing. When Chairman Alan Greenspan made his December 1996 "irrational exuberance" speech, the stock rally was 14 years old, a good time to curb excesses. But rhetoric was all Greenspan deployed.

There was no action. The gun-shy Fed didn't even send a sobering signal by raising margin requirements, the amount investors must put up to borrow for stock purchases. So rampant dot-com speculation unfolded. The bubble, rivaling that of the late 1920s, spilled over to make the economy hyperactive.

When the Fed finally got serious and started to tighten in June 1999, it was too late. Then, as stocks collapsed, the credit authorities shifted to massive easing to save the economy from a horrible recession and to fight deflation.

Unfortunately, this did little to stamp out the excesses, which simply shifted into housing and consumer spending. With low rates, money for mortgages and credit cards remained ample. Tax cuts and leaping government spending helped fuel the spend-a-thon. The value of owner-occupied residences mushroomed from $8.7 trillion in the fourth quarter of 1997 to $15.2 trillion in the first quarter of 2004, bringing along with that much higher debt burdens. The home equity craze allowed people to plunge even deeper into debt to buy flat-screen TVs, boats and vacations.

A nationwide fall in house prices, the first since the 1930s, would be devastating to the 69% of American households that own their own abodes. Big mortgage financers Fannie Mae and Freddie Mac, with $1.7 trillion in debts, could require government bailouts.

Securities speculation has lived on as well, merely changing form. Despite the Nasdaq's 78% fall from peak to trough, memories of the 18-year bull market proved hard to extinguish. Investors never reached the puke point, where they swear never to buy stocks again. Those investors who still believe 20% annual returns are their birthright moved from equities to hedge funds, which leveraged their $800 billion with derivatives and doubled-up trades.

Low rates spurred the hedge funds, banks and other financial players to pour into the carry trade. With a 1% federal funds rate here and a zero central bank rate in Japan, they had a lovely time borrowing short term and investing long, where the yields were higher. Open interest in 10- and 30-year Treasury futures contracts as a percentage of outstanding issues rose from 15% in early 2001 to 35% recently.

Speculators also borrowed cheap short-term money to buy commodities, foreign currencies, U.S. junk bonds and emerging market debt and equities. Sure, other reasons existed for strength in these areas. Copper benefited from robust U.S. home building and reviving global growth. As usual, however, speculation carried price rises to extremes. Copper's price jumped 110% from October 2001 to March 2004.

But when strong employment gains appeared in early April and the Fed made clear its rate-hike plans, markets immediately ran way ahead of the central bank. Since Apr. 1 the year-end federal funds rate anticipated in the futures market has jumped a full percentage point. The same occurred with inflation-sensitive ten-year Treasurys. Junk bonds, emerging market stocks and bonds, commodities and foreign currencies all nose-dived. Copper prices dropped 15% from their March peak.

Still, few speculative trades have been unwound so far. This is vexing since leverage is much greater than in 1994 when Fed rate increases also caught speculators off guard and killed broker Kidder Peabody, the finances of Orange County, Calif. and the Mexican economy. For example, overnight borrowing to finance fixed-income investments, in relation to the total size of the fixed-income market, has doubled since then. Which large financial institutions might succumb this time?

Hedging techniques are better than they were ten years ago. Yet remember that hedging can transfer risk but not eliminate it. The basic question: On balance, is risk being transferred from weak to strong hands or from strong to weak? I'd bet on the latter. Weak, desperate players are assuming big financial risk.

The Fed's in a tight spot. To avoid appearing impotent, it must confirm market anticipations with much higher rates. And that could be deadly for leverage speculators who have been encouraged by Fed inaction and actions since 1996. These are worrisome times that require equity investor caution. If troubles come, Treasurys will benefit as safe havens amid, I expect, a shift from inflation fears to deflation fears.




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