Watching the markets closely

Aug 20th 2007
From Economist.com

Nerves jangle, but markets are rising

AFP

ALFRED HITCHCOCK once said that his job was to provide the public with beneficial shocks. After an evening of exhilarating terror, filmgoers would check that their doors were locked and their windows shut a little more carefully before climbing into bed. The trampolining markets of the past few weeks have already administered this kind of fright, reminding investors that risk is just that. So is this the kind of drama where a few bodies are carried out and then life continues as normal? Or is an indiscriminate maniac stalking the world’s bourses?

Predicting markets is as hubristic a business as tattooing a sweetheart’s name on a bicep, particularly at times of high volatility, when normal rules no longer seem to apply. But it is possible to set out the boundaries within which the question will be answered, and point to some things to watch for.

The big one is whether traders in London, New York and Hong Kong collectively decide to go with rallies on the Dow Jones and the S&P 500 at the end of last week. On Monday August 20th the early signs were that they would, as markets rose in Asia and Europe. That came after the Federal Reserve announced a cut in the rate at which banks can borrow from it in extremis from 6.25% to 5.75%. The Fed also announced that it would provide discount lending for up to 30 days. The Federal Open Market Committee hinted that policy rates might be on their way down soon as well, saying that it was “prepared to act as needed.”

Hopefully this will take away some of the mutual suspicion that has stopped banks from lending to each other, sending short-term interbank interest rates to punitive levels. The normally staid money markets will be watched closely this week to see if it has worked. If not, something like a banking crisis could ensue.

A second thing to look out for is what broad measures of risk, such as the price of the yen against the dollar, are doing. Steep falls in yields on American Treasury bills (the purchase of which is the financial equivalent of stuffing notes under the mattress) would be another sign that investors think this storm will continue for a while.

Even if markets do continue to rally this week, the suspense will not entirely go away. The financial system does not make for such tidy endings, because it will take some time to discover who has lost what. And the Fed will be anxious too. If its market interventions do not work, investors will pressure it to offer a generalised bail-out by cutting the federal funds rate. If it bows to such pressure too quickly, the Fed will be accused of preventing a beneficial shock, and perhaps increasing the chances of a malign one later on.