The Market and the Millenium
Jude Wanniski
October 29, 1999


There are two major risks confronting the financial markets: The unknown of what the Fed will do before Y2K and the unknown of what it will do after Y2K. Fed Chairman Alan Greenspan's remarks last night are being cheered by the markets today because he clearly indicated he sees inflation as under control, even with the economy expanding at a rapid rate. His reasoning -- ad hoc and unique -- is not exactly coherent, though: The rise in real long-bond yields might slow the economy enough so further rate hikes are unnecessary. This new dictum in the Greenspan Standard implies that a rally in the long bond increases chances he has to snuff it out to prevent the economy from growing faster and igniting inflation. The markets don't care about the illogic -- any excuse not to raise rates is good news. But the futures market remains as anxious today about Y2K as it was before the Greenspan speech. With two months to go, Greenspan and other public opinion leaders offer daily soothing assurances that Y2K will only be a problem if the public panics.

The credit market tells a different story. Costly defenses are now being taken to insure against exposure to rollover risk. There is absolutely no doubt in our minds that the bulging risk premia now being discounted in certain asset classes reflect serious doubts about Y2K. The only rosiness is that there would be major buying opportunities provided the century turn is encountered without major systemic dislocation. The most conspicuous marker of this uncertainty is the soaring premium being paid to secure year-end liquidity. At 6.20%, the 3-month London inter-bank offered rate (LIBOR), the global benchmark for short-term dollar borrowing, is up 70 basis points in the last month. Most of the move came on September 29, when contracts maturing in three months rolled into the Y2K period. Money market analysts appear baffled that the premium has remained at these levels even in the face of well-advertised and pro-active Fed efforts to ensure that the market is provided with sufficient liquidity at the turn. Earlier this month, the New York open market desk executed two 90-day repurchase agreements -- a record length for these transactions -- to provide a daily cash injection of $11 billion into the second week of the new year.

We are extremely doubtful the Fed is actually prepared to alter its open market procedures to handle the Y2K pressures. As long as it sticks to its rigid funds-rate targeting mechanism, its Y2K strategy will only amount to a transparent gesture to placate market fears. For the policy to actually work, the Fed has to permit the funds rate to fall below the 5.25% target. It did trend as low as 5.05% last week. But then the desk drained $2.5 billion in reserves, persuading us the drift below target was unintended. This week, the desk has kept funds above target, averaging 5.30%. 

Mirroring the premium on short-term cash holdings, meanwhile, has been the discount on any kind of riskier credit instrument that must be carried through the millennium change. This is seen in the 70 basis point spread that has opened up between top-rated 90-day commercial paper coming due following the new year (6.17%) and 60-day paper maturing in December (5.46%). The attached chart, in fact, shows the 90-day/60-day CP spread moving to fully equilibrate with the rise in the LIBOR borrowing rate. Equally disconcerting are indications that this aversion to non-cash assets is spreading even to longer-term quasi-governmental paper. Ten-year Fannie Maes, for example, now trade at a 70 bps spread to the comparably dated Treasury, versus a long-term average of about 40 bps. The rally of the past two days on reduced risk of further immediate Fed tightness has had little or no impact on these Y2K-risk indicators.

This movement in financial asset prices is a clear "time-preference" shift, an increased discounting of future relative to present goods. The shift is affirmed in the portion of accelerating inventory accumulation documented in yesterday's GDP report attributable to Y2K, essentially bringing forward future spending. It could also, though, provide part of the explanation for the rise in real Treasury yields. Expectations of additional Fed rate hikes have been a major factor, to be sure, but a shift favoring current over future goods would also push up real rates to equilibrate the market's preference for a sum available today with the same sum available at some future date. The long bond rally which has brought the 30-year yield below 6.2% from above 6.3% during the past two sessions does not invalidate this possibility. A strict interpretation of the two-year note as only reflecting funds rate expectations would, at 5.8%, suggest the market is continuing to price for more than 50 basis points in funds rate hikes. This strikes us as implausible.

From this vantage point, the outlook through the millennium turn can be seen as strewn with risk, yet also some opportunity. The potential for serious systemic disruption obviously has not been allayed by the "We have nothing to fear but fear itself" chorus. Recent Nobel laureate Robert Mundell warns of the threat to global commerce resulting from potential seaport breakdowns, as well as the risk of monetary instability. He has called on Treasury Secretary Lawrence Summers to convene a quickie monetary summit to stabilize foreign exchange rates and the price of gold for the next several months. "It is important to remove any unnecessary uncertainty," he said in an interview last weekend with CBS. Forex volatility "would become enormously more difficult to deal with when computers go down." A hint of the pressures which may lie just around the corner is seen in indications of a nascent flight into the dollar, apparent in the liquidation of some $10 billion in foreign central bank dollar holdings since the end of last month. This is the first such reversal in central bank dollar reserves since conclusion of last year's Asia-Latin America currency crisis, which drained some $60 billion from foreign central bank coffers. Should such dollar demand intensify, it could mean at least a short-term pay-off for dollar-denominated debt. At this point, though, we can have no particular confidence that the dollar -- or any other major currency -- is prepared to withstand the coming Y2K test. Unless the Mundell dollar/gold fixing equates the dollar and gold as safe investment havens, the likelihood would be gold and other hard assets alone getting all the safe-haven play.