damned if you - damned if you don't

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    The moment of truth
    From The Times
    March 31, 2004
    LEGENDARY currency speculator George Soros reckons there is a "moment of truth" just before the climax of every financial bubble - when investors realise the story driving the market up is no longer believable.

    Although the markets usually continue to follow the bullish trend for a while, even after the "moment of truth", they do it with increasing volatility and without conviction.

    This week could see such a moment of truth in many, if not all, world financial markets.

    In the past 12 months the two most important markets in the world - the euro-dollar currency trade and the US Government bond market - have experienced a bubble even larger and more all-embracing than the 1999 internet boom.

    This bubble has been driven by two convictions.

    Firstly, US interest rates will remain near their present record lows for the foreseeable future, because the American economy is failing to produce enough jobs to satisfy the Bush administration and the Federal Reserve Board.

    Secondly, the European economy is securely on the path of recovery and will need no support from interest rate reductions by the European Central Bank.

    In the days ahead, these propositions could well be challenged.

    European Central Bank president Jean-Claude Trichet in a German newspaper interview last week delivered his strongest hint of an imminent rate cut.

    Trichet's comment was significant, coming less than a week before tomorrow's policy-making meeting of the ECB Council.

    It suggested the Madrid bombing, combined with the popular revolt represented by the German and French regional elections, might finally force Europe's policy makers to accept that the European economic recovery they were all predicting is turning out to be yet another mirage.

    More importantly, Trichet's interview, backed by influential ECB chief economist Otmar Issing, seems to signal a change in European monetary philosophy.

    For the first time since the euro was created five years ago, these ECB officials seemed to be admitting what has long been obvious to their counterparts in the UK, the US and Japan - interest rates must not only control inflation but promote economic growth.

    If the ECB follows through on this hint of sanity (a big "if" with the ECB), this week's council meeting could mark the beginning of Europe's convalescence after a decade of policy-induced economic stagnation. But the good news for European businesses and workers could prove very painful for the many bankers and investors who have been piling into the overvalued euro in the past two years.

    The rising value of the euro has, in fact, been a far bigger problem for the European economy than the level of interest rates and it would be mainly by pushing down the value of the euro that an ECB easing could achieve its beneficial result. The trouble is a sharply weaker euro would do serious damage to the multi-billion-dollar bets taken out against the greenback by speculators around the world.

    That, in itself, would be no cause for regret but the liquidation of speculative euro investments could coincide with an even bigger disruption to global financial markets, in view of this week's second and even more important economic event.

    This will be Friday's publication of US employment figures for March, which have gained totemic status for the global economy.

    This is because rapid jobs growth has been identified by Alan Greenspan as the final piece of evidence which his Fed needs to see before it can pronounce the US economy to be fully cured after its recent brush with recession and deflation.

    Once the monthly employment figures are unmistakably rising, Greenspan will have no further excuse to keep US interest rates at 1 per cent.

    That, in turn, could mean that a clear improvement in US employment, while it will be greeted with relief by American businessmen and workers, could be very bad news for investors around the world.

    Judging by almost every available economic indicator, the US economy is booming.

    GDP is now growing at its fastest rate since 1983, with consumption, housing and car sales all hitting records.

    Employment, identified as the mysterious soft spot in this expansion, is also doing well.

    The unemployment rate has been falling steadily for eight months, is much lower than it was in any previous economic recovery and is 1.5 percentage points below the corresponding point of the 1991-93 cycle.

    The number of Americans with jobs has been rising steadily for two years at exactly the same rate as it did in the last recovery.

    Weekly claims for unemployment benefits, the most accurate and timely measure of the state of the US labour market, have also followed the same pattern as they did in 1991-93.

    But amid all these indicators of robust growth, there has been one exception: the monthly payroll figures that measure job creation by surveying employers rather than the workers.

    These payroll figures started growing only last northern summer and have been rising by an anaemic average of just 60,000 a month, in contrast to monthly growth of about 200,000 during normal steady economic growth. There are numerous theories about why payroll growth has failed to reflect the general improvement in the US labour market in the present cycle - most plausible is an upsurge in self-employment.

    Whatever the explanation, the divergence between the figures will sooner or later disappear.

    At some point US employment will start to grow by 200,000 monthly.

    The last piece of the US recovery jigsaw will be in place and the fantasies of perpetually low interest rates that today sustain the structure of global asset prices will vanish overnight.

    Once US employment growth accelerates to about 200,000, which is the normal rate for periods of economic expansion, the Fed will be forced to start raising interest rates - and it will have to move fast. In order to bring monetary policy back to neutral from its present ultra-stimulative setting, the short-term rate, which is 1 per cent, will have to rise towards the UK level of 4 to 5 per cent.

    If the Fed refuses to move back to a neutral monetary policy, the fears of inflation in America will quickly grow.

    Either way, yesterday's level of long-term US interest rates - just 3.8 per cent on 10-year bonds - will prove completely unsustainable once US employment figures rise.

    Assuming that US bond yields rise to around 4.8 per cent (taking yesterday's level in Britain as a reasonable benchmark), share prices on Wall Street will also be in for a difficult period.

    Confirmation of US economic recovery, far from vindicating the high equity valuations on Wall Street, could signal the end of the global stock markets' bull run.

    A similar warning could, of course, have been sounded on the first Friday of every month (and usually was).

    But that is exactly my point: investors are now so accustomed to "disappointing" monthly payroll figures that even a number in line with market expectations will come as a shock.

    Yet economic developments in America in the past few weeks suggest the market consensus - which suggests a 100,000 payroll number - may be too cautious.

    Ian Shepherdson, chief economist at High Frequency Economics in the US, notes that the end of a supermarket strike in California should add 70,000 to the March payrolls, according to the Bureau of Labour Statistics.

    The end of February's harsh winter could easily create another 50,000 jobs.

    Adding these figures to an underlying monthly gain of 75,000 leads Shepherdson to predict that Friday's figures will show 200,000 new payroll jobs.

    If this prediction is anywhere near right, the markets are in for a big shock since there has not been a single month of payroll growth of over 100,000 since February 2001.

    In truth, no economist can accurately forecast monthly blips in employment, since these are essentially random (according to the BLS, any movement in payroll employment smaller than 108,000 should be regarded as statistical noise).

    It can be said with certainty that monthly employment figures will eventually confirm evidence of rapid growth now apparent in all the US statistics.

    At that point, politicians and businessmen may celebrate but financial markets will face their moment of truth.

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