Dump and Run

The United States had enjoyed a Goldilocks economy: not too hot, and not too cold, but just right. Growing, but not so fast as to spark inflation. Then the May mayhem ended that fairy tale. Emerging markets tanked, commodities plummeted and stocks in the United States and Europe gyrated on fear that central bankers may have to continue to raise interest rates to fight inflation. If rates go too high, the economy could cool off fast. "Goldilocks has gone missing," says London market strategist Pelham Smithers.

This turmoil also marks the end of another fantasy of sorts: the easy money created by years of historically low interest rates. After the dot-com bubble burst in 2000, the U.S. Federal Reserve cut rates to 1 percent by June 2003, unleashing a torrent of super cheap loans that sent money sloshing into one asset class after another--stocks, bonds, real estate, commodities. Even after the Fed started steadily raising rates the following June, commercial rates stayed low, and the buying binge continued. Morgan Stanley chief fixed-income economist Joachim Fels says the amount of money in excess of what the real economy needs to grow has soared by about 50 percent in the past decade. Only in the last two quarters has that mounting pile of cash finally peaked and begun to fall. Fels believes it will shrink further as central banks (including those in Europe and Japan) push rates higher. "We're seeing the end of easy money," says Berkeley financial historian Barry Eichengreen. "Hopefully it will be the happy conclusion of the story."

Ironically, markets are unnerved largely because the world of money is threatening to return to normal. Money managers had it easy when then Fed chairman Alan Greenspan measured out predictable rate hikes. "Will rates stay stable, go up, go down--we now don't know," says Jesper Koll, chief economist for Merrill Lynch in Japan. "We're in a trendless world, so people have to learn how to invest again, and that creates volatility." Similar concerns dog the U.S. economy: will it grow too fast (sparking inflation) or too slowly (if higher rates choke off growth)?

Even normalization can be risky. As central banks make money more expensive by raising the rates they charge to banks, bond yields also go up. This makes it harder for companies to borrow and for consumers to obtain cheap mortgages and credit cards. The weak will be exposed. As Warren Buffet once said, only when the tide goes out can you see who is swimming naked. If a shock comes--from oil or China or who knows where--and a heavily leveraged bet takes down a big bank or hedge fund, "then people will begin to worry about the stability of the financial system," notes Eichengreen.

Of course, the most critical link in the system is the United States and its mounting deficits, which have reached a staggering 7 percent of GDP. Pessimists have been warning about this for years to no avail. But after the April 22 meeting of the Group of Seven top industrial countries, the concluding statement had a surprise: the leaders acknowledged for the first time that currencies have to adjust to help rebalance the world economy. Put simply, the United States needs a cheaper dollar to pay its dollar debts. The rule of thumb is that the dollar has to fall 10 percent to cut the current account deficit by 1 percentage point of GDP, which means another 30 to 4o percent to cut the deficit in half. The trick will be for the markets and policymakers to produce a smooth decline, not a mad scramble out of the dollar. "We need to suck out liquidity without slipping into recession," warns Joseph Quinlan, chief market strategist for Bank of America.

No single crisis triggered the sudden shift in mood: there was the G7 communiqué, followed by remarks from the IMF on the deficit problem and new signs of inflation in the United States. The markets, which had expected the Fed to stop raising rates at 5 percent, now worry that it will push rates to 6 percent or higher, says Quinlan. What the market wants to see is clear evidence that the U.S. economy is slowing to a noninflationary growth rate of about 3 percent, so the Fed can stop hiking rates. "Oddly and perversely, bad economic news on growth is good for the markets, and vice versa," says Quinlan.

People are also watching closely for the end of the so-called carry trade in yen, in which investors borrow yen at Japan's near-zero interest rates and use them to chase much-higher-than-zero returns--everything from oil futures to Turkish stocks. Though there are signs that Japan plans to end the zero-rate era, there is no way to accurately measure the size of the carry trade, says Koll. He says talk of an end to the carry trade is probably more of a market scare than a real shift in global money flows. He also notes that a much bigger carry trade involves U.S. consumers' borrowing cheaply to buy houses, then taking out second mortgages to buy all the stuff to fill them. American consumer spending makes up 20 percent of the global economy, and Japan accounts for about 11 percent.

In general, it's very hard to put a number on exactly what analysts mean when they say there has been "too much money" chasing investment returns. Fels, looking at "narrow money" (cash and checking deposits) in the G5 (United States, Eurozone, Britain, Japan and Canada), finds that money has, in the first quarter of 2006, started to grow more slowly than the economy. This last happened in 1999, presaging the bursting of the high-tech bubble, and in 1993, leading to the 1994 crash in the bond market. Using a broader definition that includes electronic forms of money, UBS global economist Paul Donovan says money growth is already way down from the peak excess in 2000-2001. "In terms of the real economy, the era of easy money ended two years ago," Donovan argues, and now the markets are finally reacting.

For the first time in a long time, investors are describing the markets with four-letter words. Because any squeeze on money, perceived or real, tends to hit overvalued investments the hardest, there has been a frenzied sell-off in commodities like copper, platinum and aluminum. Emerging markets have been hit as well, especially India and Turkey, where the economic fundamentals are not strong. Fund managers are rotating into safe havens, such as U.S. Treasuries and large-cap stocks--those with a market value of more than $10 billion, which have been languishing since 2001. That bodes well for stagnant blue chips, from IBM to GM. It also bodes well for cash: pension-fund managers can get 5 percent returns on cash risk-free at a time when the average hedge fund is getting only about 7 percent, before fees. "You do need a good reason not to be in cash," says Smithers.

The era of easy money may be ending, but Fels, for one, is not convinced that this will actually squeeze out all of the excesses and imbalances of the global economy. At some stage, perhaps mid-2007, central bankers will cut interest rates again and then we'll be in a new liquidity cycle, he says. We'll continue to live in an asset bubble with occasional corrections. Pop one of these serial bubbles and a new one gets pumped up. "It is virtually impossible to correct the imbalances without a deep global recession," says Fels. "We are still prisoners of past deeds." Maybe the worst is yet to come.