Study of Signals

[j.c.]

Richard Beales: Bad omens

By Richard Beales in New York 1 hour, 32 minutes ago

The first chairman of the US
Federal Reserve, Charles S. Hamlin, took office in August 1914, less than a week after Britain declared war on Germany. His successor two years later, W.P.G. Harding, had been in charge only eight months when the US entered the first world war.

Indeed, every Fed chairman has had a crisis to deal with in his first year - or so Jack Malvey, chief fixed income strategist at Lehman Brothers (NYSE:LEH - news), only half-jokingly observes.
Alan Greenspan, the incumbent, had his own baptism of fire when stock markets crashed in October 1987, two months after he took office.

Mr Greenspan's tenure is set to end next January. Those in the running to succeed him might wonder what surprises the financial markets have in store for them. No one can foresee the exact shape or timing of the next crisis. But, despite historically low volatility and other benign conditions in financial markets, many worry that we are closer to the next market shock than to the last.

That occurred in 1998, when problems in Asia and Russia precipitated the near collapse of the Long Term Capital Management hedge fund. That, at least, was the most recent genuine systemic threat to the financial system, according to a report published last week under the leadership of Gerald Corrigan, Goldman Sachs (NYSE:GS - news) managing director and former chairman of the New York Federal Reserve.

The previous such shock, by the same definition, was the 1987 crash that greeted Mr Greenspan. The only other example in the past 25 years was the emerging market debt crisis that began in August 1982 when Mexico announced that it could no longer afford to pay interest on its debts.

Mr Corrigan believes the financial system is more robust than it was in 1998, thanks in part to the "therapeutic" effects of LTCM and subsequent lesser crises. But he warns against the delusion that the risks have disappeared. "There will be another financial shock," he says.

Aside from the first-year curse for Fed chairmen, some doomsayers use another rule of thumb: US presidents stoke economic growth as they approach the end of their first term, with the result that conditions can only deteriorate soon after they are re-elected.
President Bush's huge first term tax cuts fit the story; the hangover headache, however, is yet to start throbbing.

Where might the Cassandras look for trouble? While a war like the one that ambushed the early Fed chairmen might seem unlikely, another act of terrorism on the scale of 9/11 is not unfeasible. But because neither the probability nor the impact of such an event can be quantified, the markets tend to ignore the possibility.

The potential for macroeconomic shocks is also hard to assess. What would be the effect of a plunge in the dollar, for example, perhaps triggered by concerns over America's fiscal deficit? Or of the feared sell-off by Asian central banks of their huge holdings of US government and agency bonds? Or an abrupt economic slowdown in China?

Other events should be easier to foresee. Investors in corporate and emerging market debt could, for example, look ahead to the almost inevitable turn in the credit cycle and demand higher premiums to compensate for the risk that today's historically low default rates will eventually creep upwards. Instead, lenders seem to be getting less demanding, not more.

That has certainly been the case for many lenders involved in the roaring US property market. Yet the consequences of even a localised downturn could be severe - credit problems in the mortgage market or, perhaps more likely, a collapse in consumer spending, the keystone of the US economy.

None of these things have happened yet. And if some in the financial community appear complacent, it could simply reflect John Maynard Keynes' observation that "a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation".

By the same token, the investment environment can turn sharply negative "if the animal spirits are dimmed and the spontaneous optimism falters", as the great economist put it.

That suggests even the weather might affect the markets - as Keynes pointed out. And The simple fact of Mr Greenspan's absence after more than 18 years could be unnerving for some.

Whoever takes over at the Fed will be hoping that the unfamiliarity of a new chairman will not, by itself, be enough to dim the animal spirits of the financial markets.

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