Fed unlikely to give storm victims and traders a safe haven
Financial markets these days are highly efficient, but that does not mean they are always rational.
Take last week. As media coverage of the New Orleans floods revealed the scale of the destruction wrought by Hurricane Katrina, financial markets responded fast - only not in the way observers might have expected.
Alongside the buying of 'safe-haven' assets, which typically occurs in a crisis, opportunistic traders and investors bid up the prices of riskier plays, such as Asian stocks and currencies.
The thinking behind the trade ran something like this: the economic damage inflicted by Katrina is so great that it is likely to affect the growth prospects of the United States, the world's largest economy. Under the circumstances, the US Federal Reserve is highly unlikely to continue to raise interest rates when its board meets on September 20 and will instead hold short-term interest rates steady at 3.5 per cent. If the Fed then holds at its November meeting too, interest rates could end the year half a percentage point lower than everyone had been expecting before the storm blew in.
That would amount to a big turnaround in market expectations and traders rushed to revise their positions, bidding short-term US dollar interest-rate futures sharply higher (because of the way futures markets work, higher futures equate to lower interest rates).
In Hong Kong, Hibor interest-rate futures dutifully followed their US cousins, adjusting to indicate an anticipated year-end interest rate of 3.75 per cent last Friday, compared with an implied 4.14 per cent the previous Tuesday. It is likely the market has got it wrong. Experience has shown that disasters like Katrina have surprisingly little impact on the overall US economy. There is a lot of temporary disruption, but once things begin to get back to normal, people make up for lost time
In the longer term, the extra reconstruction activity makes up for losses from the damage, smoothing out any adverse impact on overall growth. The financial markets' response to the storm had less to do with concern for the affected states, which make up only about 3 per cent of the US annual gross domestic product, and more with fears that Katrina could cause a long-term rise in the price of oil, which would act as a drag on economic growth.
But while an easier interest-rate policy could boost demand, the oil price problem is one of supply. Katrina shut down about 20 per cent of US oil refining capacity, and the fear is that it will take a long time to get all the refineries working again, leading to supply bottlenecks, higher prices and a slower growth.
That scenario could still materialise, but if it does, it is difficult to see how an easier interest-rate policy would make much difference. As the Fed is already concerned about inflationary pressure in the economy, it is far more likely to stick to its guns and continue its modest interest-rate rises.
Storm victims, and financial traders, will have to look elsewhere for relief.