Punch in The Eye

By Barbara Rudolph

The bad news hit the financial markets last week like a right cross from Heavyweight Champ Mike Tyson. An unexpected rise in the U.S. trade deficit ! knocked down the dollar against foreign currencies and sent the U.S. stock and bond markets reeling. Combined with an alarming surge in producer prices, the disappointing trade figure for February increased the odds that the Federal Reserve Board might feel compelled to raise interest rates to stabilize prices and defend the dollar. With that, the threat of a downturn -- and another stock-market crisis -- loomed once again.

Things had looked quite different early in the week, when optimism about trade ruled the markets, stocks were climbing, and everyone seemed to have forgotten that the Dow Jones industrial average had fallen 508 points last Oct. 19. The upbeat mood was shattered at 8:30 a.m. Thursday as the Commerce Department's report on merchandise trade flashed across TV screens and computer terminals. Investors, who for the most part had been expecting a continued improvement in the trade balance, were stunned to see that the February deficit was $13.8 billion, an increase of 11% from the $12.4 billion shortfall recorded in January. Within minutes, currency traders in Western Europe drove the value of the dollar down by about 2% against both the West German mark and the Japanese yen.

Wall Street had to wait until the 9:30 a.m. opening bell at the New York Stock Exchange to display the full force of its displeasure, and then the Dow started 45 points below Wednesday's close. Traders tried to sustain a morning rally, but by midafternoon, prices were falling across the Big Board. At the end of the day, the Dow was down 101.46 points, its fifth worst drop in history.

Significantly, it was the steepest plunge since the New York Stock Exchange on Feb. 4 adopted rules that are designed to curb the volatility caused by program trading, which involves buying and selling huge blocks of many different stocks. According to the new guidelines, whenever the Dow is either up or down by 50 points in a single day, investment firms are no longer allowed to use the Big Board's computers to execute program trades. Last Thursday the 50-point barrier was broken for the first time on the down side, and though the new regulations were invoked, the Dow kept plummeting. Brokerage houses simply used alternative methods to carry out program trades, albeit more slowly than usual. Said Thomas Gallagher, head of institutional trading for the Oppenheimer brokerage firm: "The stock market remains extremely volatile. People are still frightened by the power of program trading."

/ Whatever hopes brokers had for a rebound the next day were thwarted by another burst of bad news. The U.S. Government revealed that producer prices surged by 0.6% in March, after dropping 0.2% the month before. Though it was only a one-month figure, and one that may be an aberration, the 0.6% increase translated into an annual rate of 7%, far higher than last year's 2.1% upswing in producer prices and 4.4% hike in consumer prices. Even so, the market reacted more calmly to the news than many investors thought it would. After being down by more than 30 points, the Dow struggled back to finish the day with a modest 8.29 gain. It closed at 2013.93, off 76.26 for the week.

The Reagan Administration did its best to ease concern about the trade deficit. Officials pointed out that the February gap was still far less than the record $17.6 billion set last October. "Monthly trade figures are by their nature erratic," Treasury Secretary James Baker said in a speech at a meeting of the International Monetary Fund in Washington. Echoed White House Spokesman Marlin Fitzwater: "We think the market has overreacted to a one- time report, and we hope this thing will stabilize."

The trade picture deteriorated largely because of an unexpected spurt in imports. Americans bought $37.4 billion worth of foreign goods, up $2.6 billion from January. Virtually all that gain reflected an increase in purchases of manufactured products from abroad, particularly machinery and capital equipment. As a result, the U.S. deficit with Japan, Canada and Western Europe, the leading capital-goods producers, worsened during the month, even as imbalances with such newly industrialized countries as South Korea and Taiwan stayed about the same. Some experts, including Jerry Jasinowski, chief economist of the National Association of Manufacturers, viewed the import rise as a sign that industrial demand in the U.S. is outstripping domestic capacity. Foreign products are selling in the U.S. because corresponding American-made merchandise is unavailable. Said Jasinowski: "We are apparently not making capital investments rapidly enough."

On the bright side, U.S. exports rose to $23.6 billion, a $1.3 billion gain over January. Especially encouraging was the news that many of those shipments included expensive products like scientific instruments. Said Arthur Levitt Jr., chairman of the American Business Conference, an association of midsize companies: "The growing sophistication and variety of our export portfolio is excellent news for future American employment and economic growth."

As concern about the trade deficit rose, Congress struggled to complete the Omnibus Trade and Competitiveness Reform bill, a mammoth piece of legislation with hundreds of provisions intended to boost exports and curb imports. While lowering tariffs on some products, the legislation is meant to protect U.S. companies against imports, especially from countries like Japan that run huge trade surpluses with the U.S. Many economists suggest, however, that the package may backfire since it could spark retaliatory action against U.S. exports.

At the moment, the most controversial provision of the bill is a seemingly extraneous measure advocated by labor unions that would require companies to give workers 60 days' advance notice of any plant closings or layoffs. The White House opposes the idea, but Democratic leaders in Congress have refused to drop it. U.S. Trade Representative Clayton Yeutter promised last week that President Reagan would veto the bill if the plant-closing provision stayed in.

Some economists are convinced that only a further drop in the dollar can substantially reduce the trade deficit -- by making imports more expensive and American goods cheaper overseas. While economists have been calling for a weaker dollar for years, they are less certain about precisely how far the dollar should fall. The major industrial countries are reluctant to allow any additional dip in the dollar. The U.S. knows that a falling greenback could bring rising inflation and interest rates, while America's trading partners are worried about their export industries. Just before the trade report was released last week, finance ministers from the Group of Seven -- the U.S., Britain, West Germany, France, Japan, Canada and Italy -- reaffirmed their desire to stabilize currency markets. "A further decline or rise in the dollar to an extent that becomes destabilizing . . . could be counterproductive," the group declared.

The G-7 central bankers tried to back their words with action. When the dollar began tumbling in midweek, they quickly intervened in foreign exchange markets, buying up the U.S. currency. But the strategy only slowed the greenback's retreat, and if the trade picture keeps deteriorating, central bankers will find it increasingly difficult to prop up the dollar. Investor pressure to drive the currency down could prove overwhelming. Says Howard Wachtel, professor of economics at American University: "If the dollar really falls outside the band agreed to by the G-7 and direct intervention cannot restore it, then we risk a free fall of the dollar."

If that were to happen, it could further raise the prices of foreign goods in the U.S. and thus accelerate inflation. So could a recent surge in energy costs, which was responsible for much of last month's increase in the producer price index. Oil prices, in particular, have been climbing for several weeks and may keep going higher. Reason: for the first time ever, oil producers who remain outside the Organization of Petroleum Exporting Countries (among them: Mexico, Egypt, Malaysia and China) have agreed to meet formally with the struggling cartel. This expanded group of oil exporters, which controls 57% of production outside the Soviet Union and Eastern Europe, could try to boost prices by fashioning an agreement to limit output. While such a pact might fall apart if producers cheat on quotas, as they have so many times in the past, word of the proposed meetings, which are scheduled to begin April 23, sparked a rally in the oil markets. The price of West Texas Intermediate crude rose by almost 12% last week, closing at $18.35 per bbl., the highest level since December.

If prices in general start to get out of control, the markets will look for a strong response from Federal Reserve Board Chairman Alan Greenspan, who has repeatedly warned of the dangers of inflation. The Fed is likely to raise interest rates, if necessary, even at the risk of derailing an economic expansion cycle that is now entering its 66th month. Not surprisingly, the mere mention of a possible economic slowdown makes Wall Streeters worry about another crash. Last week, just as the Dow was cascading toward its 100-point loss, John Phelan Jr., chairman of the New York Stock Exchange, and Leo Melamed, chairman of the Chicago Mercantile Exchange, voiced concern about the stability of the markets. In testimony before a House subcommittee, they revealed that they were devising a plan to prepare for another possible collapse. Their tentative proposal: to stop all trading in stocks and stock- index futures as soon as the Dow moves up or down by a specified amount. Phelan would like to see trading halted as soon as the Dow drops by 300 points, while Melamed would close the exchanges following a 200-point loss. After Wall Street's jittery response to last week's discouraging economic ! news, such planning seems uncomfortably necessary.

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CREDIT: TIME chart by Joe Lertola

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DESCRIPTION: United States trade deficit, January-February, 1988; Dow Jones industrial average; yen per dollar, April 4-15, 1988; Color illustrations: hand with boxing glove hitting bull, dollar sign.

With reporting by Richard Hornik/Washington and Eugene Linden/New York