Friday, June 6, 2003 11:00 am
Yesterday, after days of G8 leader meetings in France and central banker meetings in Berlin, with multiple high-level speeches on the threats of deflation and weak dollar (or strong euro), and strong hints from Alan Greenspan that US rates would soon be cut further, the European Central Bank (ECB) announced that it was cutting its benchmark interest rate by one half of a percentage point. European leaders immediately praised the move, which was on the high end of expectations, hoping that it would end the rise of the euro. 

So how did the financial markets respond? European bond interest rates fell (which was expected), but the euro rose to record levels against the dollar (surprise!) and the US treasury rates rose (double surprise!). Since I was long European bonds, long euros, and short US treasuries, I found myself perfectly positioned for what happened. It's nice to be right, even nicer to be right when the consensus is against you, and even nicer to be right when you can take the results to the bank. In investing and business, being right on these types of things can make the difference between success and failure.

What does that have to do with this column? Although interest rate policies and foreign exchange may appear to be far afield of venture capital and day-to-day business management, they actually are not. For example, a significant portion of the first quarter earnings improvements by US companies, which have so excited stock investors, were actually gains on currency conversions. And the falling dollar could be evidence that capital in aggregate is now fleeing the US for greener pastures elsewhere. Understanding what is driving these macro-economic changes is critical to good decision making, whether allocating investment dollars or running a profitable business.

With various economic benchmarks hitting 40+ year records almost every week, it should be obvious to even the casual observer that this is not business as usual. Something big is going on. The economy and the world are changing in ways that are unrelated to the normal business cycle.

So what caused the surprising market reaction yesterday to the ECB rate cut?  US interest rates simply reacted more to other events, such as the auction of a large bond offering from the State of Illinois (which competes with Treasuries for the attention of domestic investors and is the first of a series of large bond auctions being queued up by cash-strapped states) and concerns that record low interest rates had "priced in" too much pessimism for the second half recovery that Greenspan was predicting.  European and US bond interest rates and the dollar/euro exchange rates were all influenced by the continued capital reallocation out of US bonds and into euro-denominated bonds, some of it reportedly by mid-eastern investors concerned that their US investments could be attached or frozen by the US government.  All of this was augmented by currency and bond traders who suddenly found themselves on the wrong side of events and were forced to unwind their bets on a stronger dollar and lower US interest rates.