Interest rates the key to Wall Street's reaction

IN the strange world of the stockmarket, news of economic strength and rising employment can sometimes be seen as bad news. So it was yesterday that the announcement of a 705,000 rise in US employment last month led to the biggest fall in US share prices since the mini-crash of 1989.

The link between rising employment and a falling stockmarket is the outlook for interest rates. Yesterday's news of strong growth in the US economy, announced with, suitable fanfare by President Clinton, means another cut in US interest rates look less likely. As it is the prospect of falling interest rates which has boosted stock markets across the world in recent weeks, signs that the party might be coming to an end were enough to prompt the Wall Street sell-off.

As well as offering some direct benefits to business, lower interest rates also push up the price of the other main home for international investment funds - Government bonds. This has in turn knocked on to a rise in equity prices, as international investors have often seen better value in shares than in evermore-expensive bond markets.

It would be a mistake to look too closely at the logic of all this. A strong economy should benefit the stockmarket too, of course, by boosting company sales and profits. However it is sentiment which drives stock markets and yesterday's US jobs news gave a massive knock to the sentiment which has sent Wall Street ever higher.

Share prices took a beating as a result, with the Dow Jones index down by over 171 points. This is its third biggest drop ever, when measured by the points decline in the Dow Jones index. However this measures overstates the seriousness of the decline. As the index has been rising steadily over the year, a better measure is the percentage decline, which came in just over 3 per cent. This is well below the 6.9 per cent of October 13th, 1989, or the massive 22 per cent plunge on Black Monday, October 1987.

However yesterday's fall is still a very steep decline and, significant, it came in very busy trading volumes. Friday was the fourth heaviest trading session ever on Wall Street.

And there may well be more toe come. The initial reaction of analysts on Wall Street was that a further drop may now be on the way in, the weeks ahead, although it will only be over the weekend that the likely market reaction on Monday will become clear.

One warning signal for next week was flashing on the US Government bond market late yesterday. Bond investors reacted in panic to the news of economic strength, because of fear that it could fuel a higher inflation rate which would erode the value of their investments. The price of Treasury bonds had their biggest one day fall in five-and-a-half years, since news broke of the Iraqi invasion of Kuwait.

This pushed the interest rate on the benchmark 30 year bond up from just over 6.46 per cent to 6.72 per cent, the highest long-term interest rate since last August.

Much will now depend on whatever indicators of the US economy are published next week. Each release will be scrutinised to see whether the February jobs report was a "once-off" or a genuine indication that economic activity is reviving.

And what will be the reaction on this side of the Atlantic. Share and bond markets already suffered on Friday, although the main decline in Wall Street came too late for European dealers. This means a weak and nervous opening on European share and bond markets is likely on Monday, followed by a nervous wait for Wall Street to open around lunchtime.