Monday, October 8, 2007

High-Yielder Frenzy: Please Don't Feed The Risk Monster

U.S. jobs data Friday and a rise in risk appetite for things like higher-yielding Asian currencies will create a fresh dilemma for the Federal Reserve - and it would do well to keep moral hazard in mind.

The September nonfarm payrolls do not yet take another U.S. interest rate cut off the table, even if the odds for an October move have faded.

Quite a few economists are still looking for a further 25-basis point reduction by the end of the year, as the Fed looks to put on some further insurance against an economic slowdown in the wake of the U.S. subprime mortgage-related mess.

But officials at the Fed should think very carefully about the prudence of another move, especially as the market seems to be moving back into risk-seeking mode.

Part of the appetite for risk stems from the view the Fed will continue to bail markets out as needed, as the "Bernanke put" replaces the "Greenspan put."

Moral hazard was always going to be an issue when the Fed initially cut rates last month. The somewhat aggressive 50-basis point move has helped create a false sense of security in the Fed's actions, and may be perpetuated if the central bank cuts again.

To be sure, markets are less sure how much the Fed may reduce rates by the end of the year.

September payrolls were reassuring, rising 110,000 last month, largely in line with forecasts. Upward revisions to August data nullified the surprise initial 4,000 fall which no doubt had contributed to the Fed's decision to cut rates last month.

Now, the November federal-funds futures contract is pricing in about a 48% chance the Fed cuts rates to 4.5% at its meeting on Oct. 30 and 31, down from a 72% chance before the jobs data came out.

March 2008 Eurodollars are fully priced for a 4.5% rate in the first quarter of next year, with about a 74% chance for a further ease to 4.25%. Before payrolls, the March contract was fully priced for a 4.25% first quarter rate.

The jobs data have spurred the U.S. dollar and the euro higher against the yen, as interest flows to higher-yielding currencies out of Japan. The euro is now trading around Y165.80.

The Australian and New Zealand dollars are also perky against the dollar and the yen with the Australian dollar hovering around 23 year highs, having briefly nosed over US$0.90 earlier in Asia.

A solid rise in Asian share markets Monday will further stoke the interest in taking risk, especially if markets continue to look for some form of further Fed easing by the end of the year.

That could be a potent mix. It is not that some interest in riskier investments is a bad thing. And it is not that the picture is hugely bearish from an economic standpoint. Rather, it depends on how complacent investors become.

This has been said several times before, but unbridled risk is what got markets into trouble in August in the first place. The Fed would do well to remember that in, in its rate calculations later in the month. Give markets another "Get Out Of Jail Free" card and the August market tumbles could quickly become a distant memory in investors' minds.

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