interest rates have yet to bite

Splish Splash

By HENNY SENDER
June 7, 2005

For those investors who might foolishly have thought that a tripling of short-term interest rates during the past year meant tighter monetary conditions, the rally in both the stock and bond markets at the end of May made it obvious that a lot of money still is sloshing around the U.S. and the world.

"No meaningful rise in the cost of credit has taken hold over the past year," says Bruce Kasmin, head of economic research for J.P. Morgan Securities. "Real borrowing rates stand lower today than when the Fed began its tightening process. Neither the equity market nor the credit market is sending a message that they are worried."

The current level of interest rates, he adds, "is an invitation to take risk."

The world, in other words, has become complacent on the back of easy money and cheap capital. Thanks to all that money, any shock is likely to pass quickly and any problem to remain isolated. "As long as there is all that liquidity, the economy looks resilient," says Ethan Berman, founder of RiskMetrics, a consultancy.

That is why, by the end of May, the markets had shrugged off the credit-rating downgrades of General Motors and Ford Motor. "It is contagion that creates real losses, and we don't see any contagion in the system," says William Dudley, head of U.S. economics for New York investment bank Goldman Sachs.

That means that the search for yield once again has come to the fore. The junk-bond market is back, emerging markets continue to be strong and the Nasdaq also is rallying. Investment firms that allocate money to hedge funds (known as "funds of funds") prefer to invest in stock portfolios in which managers make big concentrated bets. And many managers have the same bet on.

Meanwhile, in credit hedge funds, the trend is to use borrowed money, or leverage, to juice returns. But the closer that junk-bond yields fall toward those of Treasurys, the more leverage investors need to achieve superior returns. Think of compressing a spring. "You keep having to press it harder when it is already compressed and that is dangerous," says one hedge-fund manager.

Much of the rally last week in the dollar and in the bond market was the result of hedge funds covering bearish positions. While they believe the easy-money game can't go on forever, they continue to raise their stakes -- at least until the Fed moves really start to bite. So far, they have not.