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Economic Recovery Doubts Cloud Markets

Author: Jonathan Masters, Deputy Editor
August 10, 2011

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U.S. markets responded with confidence in the immediate wake of a decision by the Federal Reserve to hold down its target interest rate close to zero percent through mid-2013. The Dow Jones Industrial Average had risen by 4 percent and Treasury yields hit record lows by the time Wall Street closed on Tuesday. However, the market erased all its gains on Wednesday, as investors responded to ongoing European debt (Reuters) woes and tumult in the French banking sector.

In a public statement on Tuesday that signaled the possibility of a third round of quantitative easing (Bloomberg), the U.S. central bank said it predicted slower growth in the coming quarters and is prepared to use "the range of policy tools available" to promote a more robust recovery. Many economists hope the Fed's decision on interest rates will encourage businesses and investors to move funds from low-yield interest accounts into more productive assets, such as longer-term treasuries, corporate and municipal bonds (LAT), and riskier investments like equities. Others fear that extending the low borrowing rate risks prompting inflation or even another asset bubble.

Asian markets rebounded modestly (WSJ) on Wednesday, trimming some of their recent losses, but Japan's Nikkei, Hong Kong's Hang Seng, and South Korea's Kospi indices still remain down in double-digits. European stocks, which initially climbed on Asian gains, fell on continued fears over the continent's roiling sovereign debt crisis.

The Financial Times writes that market indicators of investor insecurity point to a bleak economic outlook, particularly near record highs of the Swiss franc and Japanese yen against the U.S. dollar. Moreover, foreign exchange investors continue to look to safe havens, including U.S. treasuries and gold, signifying a lack of long-term confidence in equity markets. "The overall problems in the United States are far from over, and the appetite for haven assets like gold is very strong," Viral Shah, a vice president at Geojit Comtrade Ltd. in Mumbai, told Bloomberg. Investors, he said, "want to opt out from the other asset classes, and that is always going to be to the benefit of gold." The price of gold spiked to a new high for the third consecutive day on Tuesday, up nearly eight percent since S&P downgraded the U.S. credit rating August 5.

However, Randall W. Forsyth at Barron's argues that the Fed's move on interest rates will limit market volatility. Low rates should decrease risk, increase a willingness to invest, and boost asset prices. The fed-funds futures market already expected the first rate hike by mid-2013, according to Forsyth, so the Fed's announcement "may help stimulate the U.S. economy with few deleterious effects."

Writing for the Freakonomics blog, James Altucher says that another meltdown like that of 2008 is "impossible." Contrasting the economic conditions of 2011 with that of three years ago, he notes that banks are now sitting on a surplus of some $1.3 trillion; businesses have $2 trillion in cash on their balance sheets; housing inventories are much lower than they were; and household debt obligations are at their lowest level since 1992.

Selected Analysis

The Fed's statement was notable in particular for its dissent from three members, who would have preferred to stay with the Fed's previous "extended period" language rather than provide a distinct timeline for the interest rate freeze. The Wall Street Journal analyzes the implications of this opposition, suggesting the policy may have been a compromise.

Writing for Project Syndicate, Nobel Laureate Michael Spence says that "the recent dramatic declines in equity markets worldwide are a response to the interaction of two factors: economic fundamentals and [the lack of] policy responses," adding that the resilience of emerging markets to the global economic downturn will not survive double-dip recessions in the United States and Europe.

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