Will Drop in Stocks Weigh On Fed's Decision on Rates?
By GREG IP, Staff Reporter of THE WALL STREET JOURNAL, Jan. 28, 2003

WASHINGTON -- Though the recent selloff in stocks gives Federal Reserve officials more reason to worry that the economy remains stuck in a soft spot, they are taking some comfort in the corporate bond and derivatives markets.

Those markets, which Fed policy makers monitor just as closely as stocks, show no great sign of stress yet.

The central bank's policy-making committee meets Tuesday and Wednesday and will issue its interest-rate decision Wednesday afternoon. The improvement since the fall in what the Fed calls "financial conditions" could be a leading factor in favor of leaving interest rates alone.

But if the latest drop in stocks begins rippling more noticeably into other markets, that could begin tilting sentiment inside the Fed toward cutting rates again. This week, Fed policy makers are likely to keep rates unchanged. They are also apt to say risks are still balanced between economic weakness and inflation, though that might be a closer call.

After the weak jobs, trade and industrial production data, if Tuesday's report on December durable-goods orders shows further declines in capital-equipment spending, some officials could be pushed in favor of saying risks are tilted toward weakness.

Still, officials generally think the latest data point to flat growth in the fourth quarter, which has long been the Fed staff's forecast, not to renewed recession. While there are few signs an upswing has begun, officials think the pieces are in place. "The conditions for continued recovery are fairly good," Federal Reserve Bank of Dallas Robert McTeer said last week.

One factor supporting continued recovery was the improvement in financial conditions. Stocks had been holding well above their October lows until intensified concerns about a war with Iraq and lackluster corporate earnings reports triggered a 10% slide in the past two weeks. With a 141-point drop Monday, the Dow Jones Industrial Average stands 9% lower than on Nov. 6 when the Fed cut its overnight interest rate target to 1.25%, a 41-year low, from 1.75%.

But Fed officials look at much more than just the Dow industrials. They also monitor stock options volatility, corporate-bond yields and a fast-growing market for derivatives that reflects expectations of corporate default. These markets, the theory is, reflect the uncertainty of investors and lenders, and, indirectly, businesses, whose investment plans are influenced by the ease of raising capital.

Last summer and fall, investors behaved like the economy was sliding into a deflationary abyss. The widespread fear was best captured in "credit default swaps." These rapidly growing financial derivatives enable a bondholder or bank to buy insurance against a company defaulting, or a speculator to bet on such a default. They are a favorite indicator of Fed Chairman Alan Greenspan.

A basket of such swaps traded by Morgan Stanley doubled from 1.3 percentage points in June -- before WorldCom Inc. disclosed a massive accounting fraud -- to 2.8 percentage points on Oct. 10, meaning the cost of insuring $100 of a typical blue-chip borrower's debt against default for one year shot up to $2.80 from $1.30. Traders were treating the likes of Ford Motor Co. as if they were a few steps from bankruptcy. "You had the corporate-governance issue, the geopolitical risks, the risk of deflation, coming together at one point in time," said Lisa Watkinson, head of credit derivatives research at Morgan Stanley.

The Fed's November rate cut and sweeping moves by corporations to strengthen balance sheets have significantly eased those fears. Morgan Stanley's swaps index dropped to 1.3 percentage points two weeks ago. It has since risen to 1.6 percentage points, though it hasn't risen "nearly as much as you'd expect given the [drop] in the stock market," said Ms. Watkinson.

In a speech in December, Mr. Greenspan noted the improvement in stocks, corporate-bond yields and credit-default swaps with approval. "The overall cost of business capital has clearly declined," he said.

Questions:

Find out more about credit default swaps from the web. How would you price a credit default swap?
How might credit default swaps figure into the decision of the Fed not to cut rates further?
Who would use these swaps?
How would the TRACERS Index move over the business cycle?