Tuesday, May 11, 2004

Attacks From The Periphery

Marshall Auerback

A precise warning from a bear - is it plausible? I tend to think we are on very shaky ground.

...The great paradox is that equity investors need to be shaken up further in order to calm the bond markets and thereby reduce the threat of systemic stress. A few more days like yesterday and perceptions will grow that the declining “wealth effect” from a falling stock market will reduce the need to tighten precipitously. In fact, a further horrendous slide in the stock market might actually shift market sentiment back in the direction of ease, which would in turn resume the process of dollar decline and thereby afford Asian central banks the chance to offer a lending hand by placing a bid under the bond market in order to preclude a crash in the greenback. The Fed and their political masters are praying that the pressure for monetary restraint will fall away naturally, via more moderate business growth and inflation signals, and that will keep the bond market vigilantes passive.

Of course, if the bond market vigilantes continue to run rampant, this creates distinct potential for the nightmare scenario: bond yields keep spiking higher, as the Fed's credibility continues to decline amid robust economic activity reports and a widening gulf between the presumed neutral and actual Fed Fund rates. In turn, the higher yields ultimately crash the stock and commodity markets, and those developments let out a ton of steam from the bond pressure cooker. But by turning down equity values in a big way (20%? 25% 30? more?), the bond yield spike will also turn the big, slow ship of housing demand and prices downward for the first time, and that change will pick up momentum over time and will prove impossible for the authorities to arrest. If this doesn’t set the stage for a massive credit revulsion, it is hard to imagine what will. The credit bubble may burst at that stage and with it, the eruption of much more systemic risk, the barest outlines of which are seen from the periphery today.

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