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Thu Feb 24 11:44:25 PST 2005

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COLLYWOBBLES
Feb 24th 2005  

This week, America's financial markets saw a few ghosts, and shivered

THE markets were looking for an excuse to turn tail, and this week they
got more than one. Spooked by fear of inflation, high oil prices and a
revolt by Asia's central banks, bonds, the dollar and shares all headed
south, in that order. By the evening of February 23rd, some poise had
been regained. But the ease with which things went wrong--albeit just a
bit--has left many wondering just how robust is the consensus view that
all's for the best in this best of all possible financial worlds. 

The problems started last week, when Alan Greenspan, the chairman of
the Federal Reserve, professed himself puzzled by the "conundrum"
presented by the flattening yield curve: the more he raised short-term
rates (six times since June 2004, by 25 basis points on each occasion),
the more already-low long-term rates fell. Markets don't like it when
the man who sets interest rates says he doesn't understand them. The
gloom deepened when new figures on February 18th showed that core
producer-price inflation was at its highest in six years: could Mr
Greenspan be behind the curve on inflation? Bond prices headed smartly
down, as investors suspected that the Fed's chairman might see a
solution to both problems in lifting interest rates more smartly up.

The next blow fell on February 21st, when South Korea's central bank,
with most of its $200 billion of foreign reserves in dollars, said it
planned to diversify away from the currency. Then, with Europe and
America gripped by a cold wave, the price of a barrel of oil for April
delivery rose back above $50. The scene was set for a sell-off, and on
February 22nd the S&P 500 fell by 1.5%; the dollar lost 1.1% against
the euro and the same against the yen; long-dated Treasuries continued
to fall in price; oil futures rose still more and so did gold futures.
Stockmarkets around the world, mostly in sympathy but with problems of
their own, slid too.

The sweepers came in overnight to clear away the mess, and by midweek
things looked better. South Korea's central bank made it clear that it
did not intend to sell dollar assets, just to buy fewer in future. Like
other central banks, it has been quietly taking on fewer bonds from the
American Treasury and more from other issuers for some time anyway. A
mild increase, of 0.2%, in core consumer prices (ie, not counting food
and energy) in January calmed--perhaps temporarily--the previous week's
fears of renewed inflation. Share prices climbed part of the way back;
the yield on Treasury long bonds dropped again; the dollar strengthened
against both the euro and the yen; and oil and gold prices slipped back
a bit. 

 How important was this week's stumble? On the numbers, not very: this
was no 1987-style rout. But there has been so little volatility in
share prices in the past two years that any sharp change is unsettling.
The VIX (or volatility index, alias the "investor fear gauge") is a
contract on the Chicago Board Options Exchange (CBOE) that tracks the
implied volatility underlying the S&P 500. As the chart on the previous
page shows, volatility used to be high, touching 45 in August 2002 and
then a lower peak of 34 early in 2003. Since then it has headed
downwards. On February 22nd, the index jumped by 17.5%--and still only
just cleared 13. Mark Hulbert, a columnist for MarketWatch, an online
news service, points out that, if historical levels of volatility
prevailed, we should expect the stockmarket to gain or lose 2% once a
month or so. This week's fall, though the largest in 21 months, was
nothing to write home about. 

Investment analysts have two theories on volatility and market
performance, and unfortunately they contradict each other. One lot
believes that low volatility suggests share prices will fall, as it
means that investors are too complacent. They have been predicting a
market meltdown for some time. The other group believes that low
volatility suggests rising markets, as well-informed investors are
rightly confident. The chart supports the latter: while the VIX has
been having a near-death experience, share prices have headed up.

 What matters most for share prices--or ought to--are the discounted
value of companies' future earnings and the relative attraction of
other investments, both of which reflect the state of America's and the
world's economy. The reason for this week's wobble is that America's
two greatest vulnerabilities--its dependence on one set of foreigners
to buy its bonds and on another to sell it oil--were exposed side by
side. VIX or no VIX, not for the last time.

See this article with graphics and related items at http://www.economist.com/displaystory.cfm?story_id=3700326&fsrc=nwl

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