The panic of '98: it lasted less than a day, but exposed a fragile stock market

Kiplinger's Personal Finance Magazine, July, 1998 by Ann Reilly Dowd

Wall Street Journal reporter David Wessel finished writing a story on Friday, April 24, that he thought might rattle the financial world the next Monday morning. It reported that the Federal Reserve Board had adopted a policy that signaled higher interest rates might lie ahead. But he was astonished at the mayhem that resulted on Monday: a panicky, 224-point free fall in the Dow Jones industrial average. Says Wessel: "I didn't have a clue just how negative it would be."

Just as unlikely was the rebound later that same Monday and the next few days, until by the week's end stock indexes were touching records yet again. The press portrayed this as a tale of high-level Fed leaks and counterleaks, ultimately corrected by good inflation news. The real story is a saga of gumshoe reporting, followed by market misinterpretations and reinterpretations that say as much about the culture clash among Wall Street, Washington and the media as about the antsy mood of financial markets. Here's the skinny on that weird week--and what it portends for you in the months ahead.

`WAITING FOR AN EXCUSE'

As First Albany investment strategist Ed LaVarnway switched on his computer screen early that Monday, prices on benchmark 30-year U.S. Treasury bonds had already begun sliding, pushing yields (which move in the opposite direction) upward. By day's end, the yield had risen to 6.06%, from 5.94% the previous Friday. "People were waiting for an excuse to sell," he says. "And then the Wall Street Journal story hit and took on a life of its own. It was the catalyst."

Meanwhile, the initial plunge in prices on the stock market ran its course, and the Dow ended the day down 147. In 390 minutes of trading time Monday, approximately $233 billion in stock-market wealth had melted away. Some savvy investors, such as Los Angeles money manager Jeff Bierman, saw the pandemonium as an opportunity. "I took a deep breath," he says, "realized that this was a necessary purging process, and picked up some great bargains: Johnson & Johnson at $68, Merck at $112, and General Electric at $82."

Some individual investors jumped ship. Hewitt Associates reports that trading volume doubled that day in the 40 corporate 401 (k) retirement plans it tracks, representing $55 billion in assets and 1.4 million investors. Frightened investors shifted only 0.1% of total assets from stocks to bond or money-market funds.

"It clearly was a panicky moment," says Scudder Kemper Investments strategist John Silvia. "The Fed had just shifted to a neutral stance in December. A lot of people were saying the evidence of economic weakness from the crisis in Asia was on the horizon. Suddenly everyone was forced to reevaluate assumptions about inflation and interest rates." Indeed, the rates on six-month Fed funds futures--a proxy for what investors believe the Federal Reserve will charge banks for overnight loans next October--moved 0.1 percentage point, from 5.6% to 5.7%, in that single April day.

THE REACTION SETS IN

Others saw behind the Journal story an effort by the Fed to forewarn financial markets of a hike in short-term interest rates, which it controls. "The fact of the story was not the real story," explains Joel Prakken, chairman of Macroeconomic Advisers, in St. Louis. He says most experts knew the Fed was moving toward increasing interest rates. "The real issue was whether this was the beginning of an organized effort by the Fed to prepare the market for tightening. It seemed to be interpreted that way on Monday."

But by Tuesday morning markets had already begun to rebound, based on second-day stories reacting to the Wall Street Journal article. The most prominent piece was penned by Washington Post reporter John Berry, who is perceived by many Fed watchers as a virtual mouthpiece for chairman Alan Greenspan. In Tuesday and Wednesday editions of the Post, Berry wrote pieces confirming that the Federal Reserve had issued a directive shifting its bias toward raising short-term interest rates. But Berry pointed out that such moves do not necessarily presage an actual rate hike.

In fact, the Fed leaned in the direction of higher rates in July 1996, but didn't raise them until March 1997. Similarly, the central bank leaned toward higher rates from May through November of last year, then retreated to a neutral stance in December in response to the Asian crisis. "Issuing a directive is a way of building consensus within the Fed's board," says Berry. But what happens after that is anyone's guess.

THE BOSOM OF GREENSPAN

By now the spin cycle was in high gear. The word sweeping through Wall Street canyons was that a Fed "hawk"--someone on its board of governors anxious to squelch inflation by raising interest rates--had leaked the March directive to Wessel to warn investors of impending Fed action. Or, in another equally bizarre twist of the tale, this source had leaked word in order to build public support for an eventual hike in interest rates.

Similarly, Fed watchers seemed convinced that Greenspan had summoned Berry to his bosom for a "deep, deep background session," which in Washington-speak means off the record and not for attribution even to an unnamed Fed source. Says Schwab Washington Research Group director Greg Valliere: "My bet is that Greenspan saw Monday's Journal and called Berry to set the record straight--that just because the Fed adopted a bias toward restraint of the economy doesn't mean it will tighten the strings soon."