The headlines scream today with plunging prices in the stock market.
On Tuesday morning President Bush said the country will see "painful and lasting" economic damage unless a bailout bill is passed.
The complete financial market response to the failed bailout, however, is positive. That’s right, I said positive. U.S. financial markets are strong.
Specifically, the bond market saw a large rally and there was also strong buying of the U.S. dollar. Investors bought large quantities of U.S. government debt looking for safety on Monday. The yield on the three-month Treasury bill fell to about 0.14 percent. The price of the benchmark 10-year Treasury note jumped over 2 percent in value, pushing the yield down to only 3.5 percent. The U.S. dollar rose in value against all major currencies like the euro and the yen. Our buck is up 3 percent against the Euro in just one week.
These lower interest rates will keep borrowing costs down for businesses and homeowners, while a higher value of the dollar will keep inflation down by lowering the costs of imports, like oil.
In a complete financial panic both stocks and bonds would fall. The financial crisis we face, and the particularly bad stock market reaction to the lack of any government action, is constrained primarily to one industry. Most of Monday’s 7 percent drop in the Dow Jones Industrial Average was driven by large drops in financial stocks like J.P. Morgan (-15 percent), Bank of America (-18 percent), Citigroup (-12 percent), and American Express (-18 percent).
Personal investors and business people alike can learn much from all the nail-biting action on Monday.
First, market action is fast and frantic, indicating rising risk factors. The VIX index, a measure of stock market volatility derived from option prices closed Monday at the highest level in since it was first published 28 years ago. This high volatility in prices means great uncertainty for us in the months to come. Therefore, personal investors must be diversified across assets, holding both stocks and bonds. A bad day in the stock market like Monday’s can be a great day in the bond market.
In turn, business managers face an uncertain economic outlook but at the same time have a great opportunity in front of them. While the price of U.S. Treasuries was rising Monday, corporate bonds issued by banks and finance companies fell rapidly raising their yields. But this is just one industry. Many corporate bond fund managers simply sold out of these companies into less risky industries. Rates on corporate debt for many industries are at an historic low. And with the prime rate 2 percent lower than last year it is a great time to be using bank debt to take advantage of good pricing from suppliers.
Mutual fund managers and other stock market investors are understandably selling out of stocks and moving money into government bonds and non-banking corporate bonds until things look clearer. There is not, however, any sign of capital leaving the U.S. and thereby threatening our many different goods and services industries. The government can forget the bailout and let investors sort out bad banks from good ones.
Without further regulation, policy makers have plenty of tools already in place to combat the credit freeze in the financial industry. The Federal Reserve can cut interest rates lower as they were in 2001 and Fed officials have already agreed to double the size of funds banks can borrow directly through the Term Auction Facility. The Federal Deposit Insurance Corporation (FDIC) is already backing loans at troubled banks when better-run banks agree to takeover. The U.S. Treasury now has the mortgage market under management through conservatorship of Fannie Mae and Freddie Mac. The Treasury can get to the root of the problem by expanding purchases of mortgage backed securities, helping out the market that started all this mess.
This may look like the worst of times, but opportunities abound for investors, bankers, businesses and government regulators alike. Hopefully, everyone settles down today and will look back on it as the best of times for investment and financial reforms.
Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.