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Strategies & Market Trends : Fidelity Funds -- Ignore unavailable to you. Want to Upgrade?

To: Julius Wong who wrote (1254)	8/9/2003 2:39:05 PM
From: Julius Wong	Read Replies (1) \| Respond to of 11457

The End of Maestro-Economics By MELVYN KRAUSS As the August meeting of the Federal Open Market Committee approaches, the Federal Reserve and friends of Chairman Alan Greenspan are frantically spinning the recent bond market meltdown and skyrocketing interest rates as a case of markets discounting future U.S. economic growth. But the bond selling began in earnest only after the June FOMC meeting when market participants came to the conclusion they had been hoodwinked into buying long-term bonds by Greenspan & Co.'s talk of deflation and alternative measures of monetary stimulation. It has not let up since. Given the still rather modest signs of economic improvement in the U.S. -- most of the growth in the second quarter was due to non-recurring war expenditure -- the extent of the bond market troubles indicate there's something more than just the market's future growth discounting mechanism at work here. That "something more" relates to Mr. Greenspan's credibility. When central banks lose credibility, investors demand a greater risk premium to hold the nation's debt. What the bond markets have been discounting in the current meltdown is less future economic growth than Mr. Greenspan's fall from grace. Clear evidence of Mr. Greenspan's loss of credibility is the recent auction of three-year Treasury notes that went badly. Even though, on several recent occasions, the Fed chairman made it abundantly clear he has no intention of raising interest rates for a considerable time to come, there still were insufficient bids for the three-year notes. This is highly unusual. With the Fed's expressed desire not to raise rates for the indefinite future, the three-year notes should be an attractive investment. Obviously, the market doesn't believe Mr. Greenspan. More evidence the era of "maestro-economics" has come to an end can be gleaned from the behavior of the U.S. federal-funds futures contracts last week. Notwithstanding Mr. Greenspan's pledge on interest rates, and after a week of mixed news on the economy, where the most important indicator -- the U.S. employment numbers -- showed continued weakness, the May 2004 fed-funds futures contract went from pricing in a rate hike of 25 basis points to a hike of 50 basis points, and at one point during the turbulent week, was even pricing in a 75 basis point rate hike by May 2004. This type of extreme volatility in the fed-funds futures contract is rare. The Pied Piper is playing his tune, but the market simply refuses to follow. This does not bode well for the eagerly awaited U.S. economic recovery. The last thing the recovery needed at this point was to contend with premature increases in market interest rates. The housing market bubble is vulnerable to puncture, the mortgage refinancings that up to now have financed consumer expenditure are still needed, and the stock market may not be able to compete with higher bond yields. Only if the expansionary effects of the fiscal stimulus overpower those of the higher interest rates will hopes for second half growth come to fruition. In retrospect, Congress should have given the American people an even bigger tax cut. Whatever . . . At this late stage, it is doubtful Mr. Greenspan can win back the trust of investors. More than others, bond-market participants adhere to the old adage "once bitten, twice shy." When the Fed chairman was caught out manipulating bond prices with insincere talk of alternative measures of monetary stimulation and a deflation problem that wasn't, he lost the trust of those who, heretofore, had been more than willing to follow him. It also doesn't help Fed credibility that it is in denial about its role in sparking the bond meltdown. According to Fed officials, it was the market that misunderstood their message -- not the message itself that was at fault for the rise in bond yields. Whether the Fed accepts it or not, the era of "maestro-economics" has come to an end. The U.S. central bank should use next week's FOMC meeting to start a new era by foregoing manipulative hype and leveling with the American people about the true state of their economy -- no rosy scenarios please. The last thing we need at this stage in a fragile recovery is for the stock market to suffer the same fate as bonds. Mr. Krauss is a senior fellow at the Hoover Institution, Stanford University. URL for this article: online.wsj.com