Is a 1987-Style Scenario Taking Shape?
Chris Temple, Editor
The National Investor
www.nationalinvestor.comIt was the Summer of 1987. The value of the U.S. dollar against most foreign currencies was falling. Fears of the longer-term impact of escalating budget and current account imbalances were taking their toll. In response to these and related factors, gold had been rising for months. Also in response, Treasury bond yields were rising steadily; the 30-year bond, then the government’s "bellwether," moved up from a level around 7% in the Spring to approach the 10% area.
In spite of all of this and growing discussion about whether the economic fundamentals justified such levels, the stock market incredibly continued to advance. In fact, through August of 1987 the Dow Jones Industrial Average’s performance was simply breathtaking. Shrugging off the growing troubles on the inflation and interest rate fronts and all the rest, the upward momentum fed on itself. Trading at under 2,000 early on in the year, the Dow peaked in August at over 2,700.
We all know what happened next. In just under two months, the Dow shed 1,000 points; most of it came in less than a week, and half of it on Black Monday, October 19. Traders were shell-shocked; after all, nothing of this sort was supposed to ever be able to happen again. Further, we were about to go into an election year; a period when, historically, markets are strong in anticipation of all the goodies to be lavished on the economy and populace by those running for election or reelection.
Yet the stock market crashed in spectacular fashion.
As the dust was settling, President Reagan appointed a commission, headed up by former Treasury Secretary Nicholas Brady, to examine the reasons why the stock market derailed. In the end, the Brady Commission identified Japan-yes, Japan-as the chief culprit. Simply put, both public sector and private investors from that nation had for several months been demanding higher interest rates on the huge quantities of U.S. government debt they were buying. This was due to their concern over U.S. monetary and fiscal policy, both of which were making U.S. obligations relatively less attractive (and more risky) than other sovereign debt. Thus, the Japanese insisted, they wanted much higher returns if they were going to put huge quantities of their own assets into U.S. dollar-denominated securities. Eventually, those higher interest rates overwhelmed the momentum and blind faith that investors had been pricing into equities.
We’re about to enter August, 2003. Again, the foreign exchange value of the U.S. dollar has been declining. Again, the government’s budget and current account deficits are growing rapidly. Again, gold has been in an up trend due to all of this, as well as to its own strong fundamentals as a commodity. And now, long-term bond yields are spiking, as foreign investors are beginning to undermine the market for U.S. debt further.
But-as in 1987-the stock market remains oblivious to all this. Ask the stock market’s bullish advocates, and they’ll tell you that yields are rising due to investors’ optimism over the economy; after all, yields always rise when Wall Street smells economic growth and, thus, rolls money out of Treasuries and into the stock market. And, to be fair, a bit of that is indeed going on.
However, the reasons for the bond market’s sell-off of the last few weeks go way beyond such a simple, intellectually lazy explanation. Investors are ignoring to their eventual peril the fact that increasing quantities of foreign-owned U.S. dollar-denominated obligations are being disgorged-a trend which, if it goes much further, can yet lead to far higher long-term rates, even after the back-up in yields we’ve witnessed since the lows of mere weeks ago.
In 1987, it was primarily the Japanese investors’ refusal to put new money (except at much higher interest rates) into financing America’s growing deficits that caused the eventual meltdown on Wall Street. Now, what we see happening is the selling of GSE (Government-Sponsored Enterprise) paper. Specifically, it’s been acknowledged in recent days that European banks-perhaps including the European Central Bank itself-have been selling some of their holdings of Fannie Mae and Freddie Mac paper. Both deteriorating U.S. monetary and fiscal fundamentals and the increasing accounting questions over those mortgage agencies specifically have apparently led to Europeans deciding that they want to reduce their holdings of assets deemed increasingly risky.
This adds to the woes-and upward pressure on yields-in the Treasury market. GSE’s are among the biggest purchasers of Treasury securities. They also use Treasuries to hedge their mortgage positions; and now, knowledgeable people in the bond pits are warning that the recent back-up in yields and decline in prices of Treasuries could take on lives of their own. This morning, the yield on the current bellwether 10-year Treasury note is moving even higher, taking out the key technical level of 4.25%. With the momentum accelerating, a further sharp rise in yields becomes increasingly likely; and the chances for a rally in bonds that would bring yields back down more becomes remote.
One reason for the increasing danger even after the rise in yields of the last few weeks is that many holders of all manner of U.S. government paper are so leveraged. As bond prices decline and yields rise, many holders are virtually compelled to sell, adding to the momentum of the market and causing selling to feed on itself. Don’t forget too that-as I wrote in last Monday’s commentary-none other than Federal Reserve Chairman Alan Greenspan himself has virtually given the green light to those wishing to sell Treasuries. He may soon regret doing so, if he doesn’t already.
While Treasury investors have had reason to reassess their previous blind faith in The Maestro, however, stock traders have yet to face such an Epiphany. If anything, cheered on by the shills in the financial media, stock investors are as cocky as they’ve been in quite a while in their belief that equities will continue to rise. Yet I have to believe that, just as reality finally decided to set in-and pretty much all at once-back in 1987, America’s fiscal and monetary mess, a declining dollar and an inexorable rise in long-term yields will pull the rug out from under the stock market once more.
The only question is when.
-Chris Temple
www.nationalinvestor.com
July 29, 2003
PLEASE REPLY TO: chris@nationalinvestor.com
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