Analysis / The End of Logic as We Knew It

Until recently, logic ruled the financial markets. Economic and other developments had an effect on investors' reactions and when the U.S. markets rose, the dollar gained ground against other currencies. The logic was that the stream of money to the American market would create a demand for dollars.

Alternatively, when the data showed rising unemployment, the stock market would surge in its faith that interest rates would drop, enhancing the allure of stocks. Today, simple logic doesn't apply - the behavior of the currency market is managing to surprise even the experts. Cause and effect do not comply with economic theory - not even reverse logic does the trick.

Last Friday, for instance, the dollar shot up 1 percent against the euro and Swiss franc, and by 0.5 percent against the yen. At that time the Nasdaq was sliding 2 percent to a six-year low, and the Dow Jones was scraping against a five-year bottom. "Nobody understands what's going on," said one bemused New York trader.

Challenging as it may be, some answers must be sought for such a violent fluctuation in the dollar exchange rates, even if only in retrospect. This is how the theories go:

l Tensions over a war with Iraq are ebbing slightly.

l Unemployment is edging down in the United States, according to data published on Friday.

l Moody's recently downgraded Germany's Dresdner Bank.


Those explanations are not really satisfactory. Tensions easing on Iraq? That is not a consensus, nor does it seem like something to bet on. Easing U.S. unemployment? That may indicate faith in the might of the American economy, but most economists don't agree. The stock market evidently thinks exactly the opposite.

As for Dresdner's rating cut, it came packaged with a warning about Allianz, Europe's No. 1 insurance company, and essentially serves as a downgrade for Germany's entire banking establishment. Some say the German banks are in no better shape than their Japanese colleagues. It may soon transpire that the entire European economy - and of course Japan's - are in a worse state than the American one, which would therefore regain its position as the location of choice for investment by portfolio managers the world over.

That's the bottom line in the financial markets. They aren't trying to locate the best investment in the best-quality asset. There aren't any such animals. They are looking for the least-bad investment. The first to identify it wins the most.

Straight link

That straight line between cause and effect is fraying in Israel too. On Sunday, shekel-denominated bonds sank to a four-year low, with yields on fixed-interest Shahar bonds rising to 12.3 percent - more than during the June crisis, when the shekel sank to NIS 5 to the dollar.

But the currency market isn't panicking. Yesterday the dollar rose 0.5 percent against the shekel in shekel-dollar options trade, but it remained within the range of the last month - NIS 4.8 to NIS 4.9. The bond and currency markets had been moving in tandem, with the forex rates controlling the rise and fall of bond yields. This is no longer true.

How did it happen? Again, investors in Israel are looking for the least-bad vehicle, while carefully avoiding reverse logic. Institutions have been cutting back their long-term vehicles and hunkering down in short-term shekel assets, with an eye on the impending tax on capital gains, and meanwhile the currency market has settled down.

Although confidence is waning that the Finance Minister can manage the budget and reduce the deficit, the Bank of Israel seems determined to keep the exchange rate under control, and will not hesitate to slam on the brake if the shekel starts to spiral.

Yet that logic could easily turn upside down too. Market players know that the worse the situation on markets, the greater is the hope that Finance Minister Silvan Shalom can push the 2003 budget through Knesset. It is also clear that the current yield gap between short-term shekel notes (9.2 percent) and medium-term yields (12.3 percent) is already too large, and could suddenly narrow.

Under these circumstances, when many people agree the economic situation is bad and no upturn has arrived, even pessimists can't figure out where to put their money. Maybe in a few months Shahar bonds will be trading at yields of 15 percent, inflation will be nearing zero, and the currency market will be trading in a narrow band. Would that be a can't-miss investment opportunity? Who knows.

The only sure bet in town is that with uncertainty brooding over the Israeli market, the security situation and the world economy, the currency and money markets are going to stay turbulent and jittery.