Taking Stock / Surprise?

Bewilderment and mortification reign again.

The dollar suddenly shot up to NIS 4.63, having risen 5.7 percent from the year's start. Stocks sank 4 percent from that spike three weeks back. The Dow Jones dipped below 10,000 points, Israeli government bonds fell 1.1 percent and the yield on unlinked bonds bounded back to 8 percent. People are pulling their money out of stock-based mutuals, and everybody's in shock. What is going on? We thought the recession was over and the rally had begun!

If you've been anxiously tracking the markets, you might wonder at developments here and abroad. Growth is resuming and now, of all times, the treacherous markets are turning a cold shoulder to faithful investors.

But the truth is that none of the above should have been surprising. The writing was on the wall, though material questions remain open.

1. The Fed funds rate in the U.S.: Long-term U.S. bonds wilted, dropping 2.08 percent in the last month and lifting yields to 4.77 percent, a level last seen two years back.

No surprises there. U.S. interest rates had been brought low because of Alan Greenspan's easy money regime, instituted in order to heat up the economy. He lowered the basic funds rate to a mere 1 percent, the lowest level in 40 years, lower than inflation. And the crowd roared.

His policy worked, too. Growth was restored to the U.S. economy, in which GDP should increase by about 4.5 percent this year.

But nobody seriously thought that this policy could be maintained over time. It was a jump-start, not an idling speed. The question isn't whether the Fed funds rate will be lifted, it's when: before the U.S. elections or after. And - by how much.

And when Greenspan does make his move, another open question is how it will affect the American consumer, the American real estate sector and profits at corporations, most of which became highly leveraged through massive buying of their shares. Will the contagious optimism remain?

2. Interest rates in Israel: On Tuesday, the yield on shekel-denominated Shahar bonds climbed to 8 percent, a 2-point gain from their level at the start of the year. Real interest derived from the yield on linked bonds has been crawling up, and crossed the 5 percent mark.

Surprise? Not really. When the disinflationary policy had done its trick and interest rates dropped close to western levels, local interest becomes more dependent on international levels. With rates in the U.S. climbing, particularly dramatic events have to take place for Israeli rates not to tamely follow skyward.

Local rates were sharply cut over the last year because of the low rates abroad, the drop in Israel's risk premium because of the massive American involvement through loan guarantees and Iraq, and the restoration of fiscal discipline.

Yet these three processes are over. The gap between Israeli and western interest rates reflects not only Israel's risk premium, but also the Israeli government's giant debt and the budget deficit. Even after the great budget cuts, the deficit will be 3 percent to 3.5 percent of GDP.

3. The war in Iraq: Finance Minister Benjamin Netanyahu received notification of the loan guarantees the night America invaded Iraq for the second time. America's involvement in the Middle East dramatically reduced Israel's risk premium, and ignited the wave of gains on the Tel Aviv Stock Exchange.

But it quickly became clear that it's much easier to get into Iraq than it is to get out.

All the advantages of the massive U.S. involvement in the region very quickly became taken for granted over here. The military collapse of Israel's eastern front and the sliding risk premium seem old.

Yet we would all do well to consider the economic repercussions if the Americans should turn their backs on Iraq, or sink deeper into the quagmire.

4. Drops on the U.S. stock markets: In another 228 days, one of the greatest financial reforms in Israeli history will be unfolding. Capital gains tax on Israeli and foreign securities will be leveled out at 15 percent. At present tax on capital gains made abroad is 35 percent. In one fell swoop, the tax aspect will stop affecting investment decisions.

Eradicating the tax shield protecting Israeli securities is a key step in integrating Israel's capital market into the wide world. It brings Tel Aviv that much closer to the markets in New York, London, Paris and Tokyo.

And if you're fretting over the Dow's weakness this week, you have good reason. If you lose sleep over the thought of Nasdaq retreating, you might well tremble on. For better or worse, we're striding along with them, hand in hand.