Days of booms, bubbles and booby traps

Cheap money has created a potentially expensive lesson

May 12, 2004|By JAY HANCOCK

WHAT'S BUGGING the stock market? Companies are finally starting to hire again. Unemployment is down. Production is up. Consumers are buying.

Yeah, all those things bother the stock market.

Welcome back to the good-news-is-bad-news good old days on Wall Street. For a brief moment there in the early 2000s, workers and stock owners were on the same side, hoping for growth, hiring and avoidance of a full-blown depression.

Adios, accord. Word that the economy created 625,000 jobs in March and April has crushed both stock and bond markets.

The weasels and badgers in Lower Manhattan often overreact to job growth, worrying that a shrinking supply of workers would drive up wages, cut corporate profits, stoke inflation and goose interest rates. But this time they may be onto something.

Here's the problem: For more than a year, banks and other investors have seized on amazingly cheap, borrowed, short-term money, courtesy of the Federal Reserve, to sink billions into almost any kind of financial asset you can think of.

Now the cost of short-term money looks as if it's about to rise, thanks to reviving job growth. The investments it financed will be dumped. Everybody's hoping to get out before the plunge. And more than a few economists worry that they won't.

The "carry trade," they call it on Wall Street. Borrowing short and lending long. Leverage. Buying on margin.

By any name, it's a sweet deal. The Fed slashed the overnight lending rate for banks to 1.25 percent Nov. 11, 2002, and then chopped it again to 1 percent June 25, the lowest level since the 1950s. The deal got even better after Fed boss Alan Greenspan repeatedly announced that rates would stay low a long time, thus assuring carry-trade players many months of risk-free profits and luring more bettors into the game.

Banks everywhere borrowed at 1 percent, bought Treasury notes yielding 3 percent or 4 percent and laid back to pocket the difference. Why sweat making loans to consumers and businesses when you can get free money elsewhere?

Nobody knows the exact size of carry-trade positions. But the general consensus is: Huge. The Grand Canyon-spread between short- and long-term yields combined with the lowest rates and strongest Fed-freeze signal in memory have presumably puffed this bubble up pretty plump.

There are clues. At the end of April, U.S. commercial banks owned $1.2 trillion worth of Treasury notes and other federal securities - up 44 percent since the beginning of 2002.

The classic carry trade involves Treasury notes, but the sheer munificence of Greenspan's generosity seems to have inspired similar plays in mortgage bonds, commodities, currencies and who knows what other assets. The recent plunging of the Australian dollar was partly blamed on exiting U.S. carry traders who had piled into higher-yielding Aussie bonds.

And, of course, stocks themselves can be bid up with cheap, short-term loans. Most stock customers can't borrow at 1 percent, but brokerage margin loans of 4 percent or lower surely contributed to stocks' stunning rise last year. Customer margin debt at the New York Stock Exchange was $180 billion in March, less than the bubble levels of early 2000 but still up a third since the end of 2002.

But all good things end, and the worry is that carry trades will not unwind quietly, despite or because of investors' attempt to hedge their big bets with derivatives.

Sooner or later Greenspan will raise short-term rates to forestall the inflation that always threatens in improving job markets. Rising rates will exert a double whammy by increasing carry-traders' borrowing costs and plastering the value of their long-term bets. Everybody will rush for the exits, and some fear a derivatives-linked disaster such as the one that floored hedge fund Long-Term Capital Management in 1998 and threatened the whole system.

Does this mean you should sell stocks? Not necessarily. Does it mean you should sell bonds? Maybe - especially low-rated bonds. But the main message is this: Combined with rising oil prices and the waning of tax-cut stimuli, carry-trade booby traps threaten the economy's ability to switch from the cheap-money engine that drove it for two years to a genuine, employment-led recovery.

Pimco's Paul McCulley calls it "the hand-off of the growth baton from Wall Street to Main Street." That's what the stock market is afraid won't happen. That's why Morgan Stanley's Stephen Roach thinks the recent economic global rebound could be "one of the shortest on record."

And that's something for everyone to worry about, including workers.

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