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Commentary: The Only Thing We Have To Fear Is Fearful Investors


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COMMENTARY: THE ONLY THING WE HAVE TO FEAR IS FEARFUL INVESTORS

Don't put on those party hats yet. The U.S. financial markets are not as healthy as you might think from the rebound in equities. Outside the newly hopeful stock market, all seats on the flight to quality are still booked. Despite two confidence-building cuts in interest rates by the Federal Reserve, the yield spreads, or risk premiums, between safe and risky assets have actually gotten wider. And risky assets aren't the only ones investors have abandoned: They're even steering clear of safe but less liquid assets, like certain U.S. government bonds that are less traded--and thus harder to unload at a moment's notice. In other words, there's a flight to liquidity as well as a flight to quality.

This kind of near-paralysis is bad for hedge funds such as the benighted Long-Term Capital Management that are betting on healthy markets and narrow spreads. But that's not all: It could be bad news for the entire U.S. economy. With conditions so hostile, junk-bond issuance and initial public offerings have nearly come to a standstill. Markets aren't performing their core function of financing companies that need capital to expand. If this goes on for too many more months, it will begin to take a bite out of economic growth and job formation.CONFIDENCE GAP. Scan the indicators and it appears that away from the stock exchanges, there's little more confidence now than there was on Oct. 7, when Fed Chairman Alan Greenspan spoke of "a broad area of uncertainty or fear" and said that investors are "disengaging." That disengagement shows up as high volatility--fluctuations in prices--and in wide gaps between the prices sellers and buyers quote each other. In the high-yield corporate bond market, active players such as Merrill Lynch & Co. usually are willing to buy big blocks of bonds without knowing to whom they'll sell them. That's known as "open-ending." But now, few firms will buy bonds without having a place to sell them already lined up. Says Martin S. Fridson, Merrill's chief high-yield strategist: "The willingness to open-end is much reduced."

It appears, as Prudential Securities Inc. said in a recent newsletter, that "investors are now motivated solely by fear and not by greed." Fear explains the distaste for junk bonds. Since July, as the top chart shows, the yield spread--the difference in effective interest rates--between 10-year BB1-rated bonds, just below investment grade, and 10-year Treasuries has grown from 170 basis points (1.7 percentage points) to 270 basis points.

The bottom chart is scarier, because it depicts an aversion even to securities in which safety is not a factor. It shows a tripling of the yield spread between 29-year Treasury bonds and 30-year Treasury bonds. The 29-year bonds are actually 30-year bonds that were issued last year. Although these securities are equally safe, they are less heavily traded than the new issues. Some investors began shying away from the older bonds, fearing that they would be harder to liquidate quickly for a full price. Their fears about a lack of liquidity became a self-fulfilling prophecy as more and more investors backed away from the older bonds.COLD FEET. Markets that are this much out of alignment are supposed to present a golden opportunity for arbitrageurs, who exploit temporary discrepancies in prices of related assets. But as demonstrated by Long-Term Capital Management, arbitrage often fails when it's most needed, says David A. Hirshleifer, a professor of finance at University of Michigan Business School. Lenders to the arbitrageurs get cold feet. And trading gets so thin that it's difficult for arbitrageurs to close out their positions at good prices. The very fact that someone wants to sell is taken as bad news. Says Hirshleifer: "Each person is afraid that the other guy knows something he doesn't know."

There's a chance, of course, that the situation will right itself soon. Stock investors' optimism could start to rub off on other investors. But it's also conceivable that it's the stock buyers who have gotten a bit ahead of themselves and that the bond pessimists will prevail. If so, the disengagement that the Fed chairman has observed could settle in for a long engagement.By Peter CoyReturn to top


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