Are "wrenching changes" about to unsettle the financial markets?

After a 19% increase in June's trade deficit, some say the risks of a sharp decline in the stock, credit and currency markets are intensifying. Indeed, comparisons to 1987 are already being thrown around.

"As America's external imbalance widened in mid-1987, the dollar came under sharp downward pressure and U.S. interest rates were pushed higher," said Morgan Stanley's chief economist Stephen Roach. "Those were the classic manifestations of a current account adjustment that many (myself included) believe were at the heart of the stock market crash of October 1987."

The U.S. trade deficit jumped to a record $55.8 billion in June from $46.9 billion in May, as imports rose 3.3% and exports fell 4.3%, the biggest decline in more than three years. While rising oil prices contributed to the deterioration, they weren't the only factor.

On an annualized basis, the deficit now accounts for 5.75% of nominal gross domestic product compared with just 3.2% of GDP in the second quarter of 1987. "Today's external imbalances dwarf those of 17 years ago," said Roach, who has long warned about the perils of an unbalanced world.

The U.S. has been able to spend beyond its means and consume more than it produces because foreigners have been willing, at least so far, to lend Americans billions of dollars. In June, international investors bought $71.8 billion of U.S. assets, up from $65.2 billion in May, according to the Treasury Department. It was the first increase since January.

Still, purchases by foreign officials have slowed sharply from earlier in the year when Asia's central banks were intervening in the currency markets. Central banks, particularly the Bank of Japan, sold their local currency to keep their exports competitively priced. In doing so, they bought dollars, which were then invested into U.S. stocks and bonds.


Federal Reserve

remains concerned about global imbalances, noting in the minutes of June's policy meeting that "outsized" deficits cannot be sustained indefinitely. While the adjustment of imbalances "might well proceed in a relatively benign fashion" and isn't necessarily imminent, the possibility of more "wrenching changes could not be ruled out."

Like some private economists, the Fed worries that there is a limit to what foreigners will be willing to lend the U.S. as the country's debt increases. When that limit is reached, some say, the dollar is likely to fall, sending import prices, and thus inflation, higher. That, in turn, should prompt further interest rate hikes, which could hurt stocks and bonds.

"Any hesitancy in these capital inflows will have negative consequences for the U.S. dollar and domestic asset prices," said Sherry Cooper, chief economist at BMO Nesbitt Burns.

Lehman Brothers' senior economist Ethan Harris said the current account deficit -- the trade deficit plus incoming and outgoing debt payments -- is set on a "persistently destructive path" and has raised the odds of a "disturbingly sharp decline in the value of the dollar."

The current account gap hit a record $144.9 billion in the first quarter, equal to about 5% of GDP.

"A dollar decline accompanied by a sharp increase in domestic interest rates to attract foreign capital would put monetary policy in a bind, forcing the Fed to temporize between the higher inflation induced by the weaker dollar and the slower growth caused by higher long term interest rates," Harris said.

Still, several economists believe the doomsday scenario is overblown. Vincent Malanga, president of LaSalle Economics, said the economies of Asia and Europe aren't strong enough to justify "a dollar crisis."

"Other areas of the world are not that attractive anyway, so it's sort of a case of what's the least bad," he said.

Japan's GDP rose at an annual 1.7% pace in the second quarter, well below the amount predicted by economists. In the eurozone, the economy grew just 0.5% in the three months ended June.

Although Malanga does expect some softening in the dollar, he thinks it will come gradually and said the trade gap will probably narrow this year because of a slowdown in consumer spending. "As consumption slows, it should moderate import demand," he said.

Steven Wieting, senior economist at Smith Barney, said that over the past 30 years, there has only been one time when stocks fell as a result of an adjustment to the large trade deficit, and that was 1987.

"We've had two decades now of very wide current account

deficits, very wide fiscal imbalances and three fairly normal business cycles," he said.

Even if the day of reckoning isn't yet upon us, the impact of the burgeoning trade deficit is starting to be felt. The sharp jump in imports and decline in exports in June took away any possibility that second-quarter gross domestic product would be revised higher, something economists had expected after recent inventory data and an upward revision to June's retail sales. Several economists, including those at Merrill Lynch and J.P. Morgan, now predict that second-quarter GDP growth could be revised down to 2.5% from 3%.

The trade report for June has "added to the gloom" of the July employment report, said Jan Loeys, global head of fixed income research at J.P. Morgan. "It is still our forecast that the Fed will hike another 25 basis points next month, but the odds on that are now close to even."