- The Washington Times - Thursday, May 31, 2001

Amid the markets impressive bounce-back rally of the past several weeks with the Nasdaq up nearly 40 percent from its April 4 low there are a number of encouraging signs that the Feds most recent moves have withdrawn a large element of deflation risk from the discounting process.
Across a variety of credit and risk-sensitive indicators, a picture is emerging of financial market participants reconnecting with the animal spirits so essential to capital formation and sustained growth. Just as the risk avoidance that first became evident about a year ago presaged the current economic slump, this rise in investor risk preference points to the economys likely return to an expansion mode, probably by year-end.
The spread between high-yield junk bonds and 10-year Treasuries, which indicates entrepreneurial access to public debt market finance, has narrowed to 750 basis points from almost 1,000 basis points earlier in the year.
Also, the spread between the 10-year note and investment grade Baa corporate bonds has narrowed to 260 basis points. Narrowing credit spreads also infer diminished profits risk. Despite a massive S&P; operating earnings drop of 16 percent in the first quarter, shrinking credit spreads are forecasting a profits recovery later in the year. This message, of course, parallels the improvement in stock market indexes since late March.
Interestingly, this rally comes even as the ratings agencies tally up the cost of the damage done to the high-yield debt sector by the Feds scorched-earth liquidity deflation. According to Moodys, junk issuers have defaulted on a record $42 billion in debt so far this year. The agency now expects the default rate to jump to 10 percent by early next year, up from its already elevated 7.7 percent rate.
However, markets are smarter and more forward-looking than rating agencies. In the face of rising defaults, April junk issuance totaled $6.6 billion, according to Moodys, more than double last years monthly average of $2.8 billion. The appeal of high-risk debt instruments suggests the market now sees opportunities to capture attractive value in assets that have been so heavily marked down.
That also would appear to be the case in higher-risk equity segments. Consider, for example, that after getting crushed by better than 85 percent from its March 2000 highs, The Street.com Internet index is now up 63 percent from its early-April lows. That low, by the way, came within two days of the dollar price of gold touching bottom at $255 per ounce. Similarly, the Bloomberg index tracking the prices of initial public offerings launched within the last year bottomed April 4, down 74 percent from its highs of March 2000, and has since gained nearly 50 percent.
Meanwhile, as the higher-risk tech-sector benchmark, the position of the Nasdaq composite relative to the lower-risk Dow Industrial average is a useful indicator of the markets relative risk preference and future growth prospects. Here, the results have been somewhat less stellar but nonetheless encouraging. After crashing by 66 percent as of the early-April lows, the Nasdaq/Dow ratio is now up by 18 percent.
Final point: The spread between emerging market bond yields and 10-year Treasuries has also narrowed to 630 basis points from 750 basis points. This shows that Fed policies call the tune for world liquidity developments. Global liquidity deflation has become less severe as a result of Fed reserve additions and interest rate reductions.

Lawrence Kudlow is CEO of Kudlow & Co. LLC, and CNBCs economics commentator.


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