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US: Moral hazard at work

Dec 22, 2000

The NASDAQ finally managed to post its first gain in eight trading sessions. The Dow too broke its two-day losing streak. Is this a sign of better things to come? Probably not. The US markets are looking up to Mr. Greenspan (the Chairman of the Fed) to bail them out for a second time in as many years. Indeed, the bond futures market in the US is already indicating a rate cut in the coming year. According to some estimates based on bond futures, there is a 100% chance that there will be a 0.25% cut in rates and a 60% chance that there will be another 0.25% cut in the first quarter of the coming year!

The moral hazard that Mr. Greenspan created in late 1998 must surely be coming to haunt him, as day after day expectations of a rate cut to boost the stock markets rise.

But should Mr. Greenspan raise rates? Again, probably not. The reason is that since the economy has grown above its potential rate for a couple of years now, there is a need for some cooling. Indeed, growth in the first half of the year topped 5%. In contrast to this, the US economy grew at a much slower rate of 2.2% in the quarter ended September.

In the meantime, US companies, from Microsoft downwards, have been turning in disappointing results/expectations. To get a grip on the situation, companies either need to shore their performances (seems unlikely in view of the slowing demand) or investors will have to lower their expectations (more likely, but does not seem to be happening as of now). Until a balance in found, the volatility witnessed in the US stock markets will persist.

In the coming days, weeks or months, the US markets will have to undo what they unfortunately did over the last few years. Then they attributed a lower risk to stocks, making valuations high by historical standards seem moderate. The rationale was that over the long run stocks perform better than bonds and other investments, and off late, returns from stocks were much more certain than ever before. However, after a year of pounding, the US markets (in particular the NASDAQ) have suffered large losses, making a mockery of earlier claims. This too will affect valuations.

The US markets still have a lot to factor in present stock prices. Whether Mr. Greenspan obliges or not is just one thing? But then, who knows, the US markets may once again rocket like they did in late 1998, after Dr. Greenspan's dose.

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