Ten days that shook the world's markets

Great Article: Sunday May 21, 2006 The Observer

From Stockholm to Tokyo, New York to Istanbul, market mayhem swept across the world last week, unleashing violent movements on stock markets and foreign exchanges everywhere, and hammering down the price of commodities such as copper and gold.

In London, the FTSE 100 suffered its worst day for more than three years on Wednesday, before ending the week at 5,672, more than 4 per cent down in five days' trading. After a febrile fortnight, analysts are asking themselves if the turmoil is over - or whether the sell-off marked the end of the three-year bull market and the dawn of a much more volatile era.

Stephen Lewis, of bankers Insinger de Beaufort, says it's too early to write off the risk that the events of the past few days could be the trigger for a full-blown financial crisis. 'Volatility rises, to the extent that it has in equity and commodity markets in recent days, when emotions take over; when actions in the markets are forced; when survival is at stake. In such circumstances, there can be no reliable forecasts of how far markets will move,' he warned.

The worldwide wobble started with the dollar. A warning from G7 finance ministers last month about imbalances in the global economy, and a hint from Federal Reserve chairman Ben Bernanke that he might halt the rise in interest rates, brought the greenback bears out of hiding, and triggered a frenzy of selling.

But over the past few tumultuous days alarm has spread far beyond the currency markets. 'The equity markets were standing rather naively on the sidelines, and suddenly they've woken up,' says David Bloom, currency strategist at HSBC, who has long predicted a dollar shake-out.
'Markets have been looking very vulnerable,' said Julian Jessop, international economist at Capital Economics. 'There have been some bubbles developing, particularly in commodities.'
All investors are waking up to an alarming new world. After five years in which credit has been plentiful as central banks kept the cash taps on, the cost of borrowing has gradually begun to grind upwards. In the US, the Federal Reserve has raised interest rates 16 times, to 5 per cent, from 1 per cent two years ago. The European Central Bank has also raised borrowing costs, and even Japan, the home of the zero interest rate for many years, has responded to a stronger economy by promising to start tightening monetary policy.

In this new climate, with money rapidly becoming more expensive, investors will be less keen to take enormous bets using borrowed cash. The unwinding of some of these risky positions was responsible for some of last week's upheaval.

'Everyone and his dog has leveraged up to the eyeballs buying everything they can get their hands on,' said Charles Dumas, of Lombard Street Research. 'Now liquidity's drying up because interest rates are high; bond yields are high; everyone's finding their funding drying up.'

One extreme example of this is what analysts call the 'yen carry trade': investors have been taking advantage of zero interest rates in Japan, borrowing the money to take bets in other markets. With rates in Japan on the way up, they have been hurriedly extricating themselves: and that has hit risky but high-yielding assets, such as emerging market bonds. Turkey took a pounding last week, for example, as nervous investors pulled their cash back home.

'We think that there's been a very big shake-out in some of the asset classes where people had become very extended, especially emerging markets and commodities,' said Peter Oppenheimer, European head of portfolio strategy at Goldman Sachs.

As if this 'liquidity drain,' as Lewis calls it, wasn't enough to spook the markets, it is happening at a time when the Federal Reserve, the world's most important central bank, is in the hands of a new boy - former Princeton academic Bernanke.

He has to win the confidence of the markets at the same time as deciding on the right time to stop increasing US interest rates. If he pushes borrowing costs too high, the US economy could be plunged into recession; if he stops too soon, the markets will fear that inflation is about to get out of control.

'He's between a rock and a hard place,' said Dresdner currency analyst Sonja Marten. 'It's a very tricky situation. There is going to be that risk of a hard landing, and that's what the markets are not sure about.'

Goldman Sachs analysts call this the 'Bernanke bind' and, at the margins, it could increase the anxiety in the markets over the months ahead. 'They're going to pressure Bernanke, which could be bad,' says Dumas.

Through the fog of market panic last week, analysts said it was important not to forget the underlying economic causes of the upheaval. For several years now, economists have been watching with growing alarm as the US spent more than it earned, running up a record current account deficit with the rest of the world - worth almost 7 per cent of GDP last year.

Funding all that surplus spending has been easy, because foreign investors - notably governments in Asia and the Middle East - have been happy to gobble up American assets, including US Treasury bonds. But, just like an overdraft, the current account deficit can't go on growing indefinitely: something has to give.

Most experts have believed for some time that a devaluation in the dollar would be the best way of helping to bring America's income and expenditure back into line. It should make US goods cheaper, helping American exporters while slowing down imports, which will become more expensive for Americans to buy. The weakening in the dollar over the past couple of weeks could be seen as the first step towards this 'rebalancing'.

All this might sound like the concern of academic number-crunchers. But the US current account deficit has a more homely analogue in the finances of the small-town American household. Buoyed by low interest rates and a property boom, consumers have, quite simply, been spending more than they earn. The savings ratio - the proportion of the average worker's take-home pay that is squirrelled away for a rainy day - has slipped below zero.

With interest rates rising, and signs emerging that the frothy property market is on the turn, American homeowners may respond by acting to put their finances back in order. That could mean a downturn, or at worse a recession, in the US economy.

'If the housing market in the US slows sharply, then that will drag down the economy as a whole,' says Jessop. And when America sneezes, the rest of the world catches a cold: European Union politicians have already started to sound the alarm about the impact of a stronger euro on exporters, for example, and China would be hit hard if US demand for its products plummeted.
For the UK, too, if the rise in sterling against the dollar is sustained, the economic consequences could be painful, particularly when combined with an American slowdown. At the beginning of last week, economists were betting on an early rise in interest rates; but the Bank could find the stronger pound does the same job.

This economic story will play out over months, not at the breakneck speed of the financial markets, and it is hard to predict how its ramifications will ripple across the world. 'There's no new trend established yet,' said HSBC's Bloom. 'It's an unsettled time.' But Bernanke, whose hands are on the world's most important economic lever, will have to hope he isn't forced to win the confidence of the markets the way his predecessor, Alan Greenspan, did - by stepping in to stop the stock market crash of 1987 turning into a global financial crisis.