Stock rout drives fear of downturn

Stocks plunged Wednesday as the dollar sank to new lows against other major currencies, in a one-two punch that deepened concerns about the outlook for the U.S. economy.

The latest rout on Wall Street was led by already-battered bank shares. That suggested that the Federal Reserve’s three-month campaign to cut interest rates hadn’t restored confidence in the financial system, which has been hammered by soaring mortgage defaults.

Adding to the gloom was another record trading high in oil prices, which have been streaking toward $100 a barrel, increasing fears of a sharper hit to consumers’ pocketbooks.

Financial markets have been counting on the Fed to continue easing credit as a prop for the economy and to help ailing lenders.

But the central bank now risks being caught in a bind, some analysts say: If it continues to lower interest rates, it could further undermine the sagging dollar and drive away foreign investors, sending markets reeling.

Washington Mutual Inc., the nation’s largest savings and loan, became the latest financial giant to warn of multibillion-dollar losses as more homeowners fall behind on their mortgages.

“The soft landing we were anticipating quickly transitioned to a severe downturn,” Kerry Killinger, the Seattle-based company’s chief executive, told investors in New York.

The Dow Jones industrial average sank 360.92 points, or 2.6%, to 13,300.02, its lowest level in nearly two months.

The tumbling dollar is compounding investors’ fears. Each decline in the greenback devalues the substantial U.S. investments of foreigners, who have been a crucial source of funding for the nation’s huge budget and trade deficits.

The dollar’s continuing slide raises the risk that foreign investors could balk at buying more American securities, such as Treasury bonds. That, in turn, could worsen the already severe credit crunch rooted in the housing market’s woes.

The dollar crumbled Wednesday after Chinese officials implied that the country might sell off dollar-denominated securities to diversify its $1.4 trillion in foreign-currency reserves.

“We will favor stronger currencies over weaker ones, and will readjust accordingly,” Cheng Siwei, vice chairman of China’s National People’s Congress, said at a conference in Beijing, Bloomberg News reported.

Although many analysts said Cheng had just reiterated what other Chinese officials have said this year, currency traders seized on his words, driving the dollar down sharply.

At the end of the day in New York, $1 bought 0.682 of a euro, down from 0.687 on Tuesday and the lowest since the 13-nation European currency was born in 1999. Five years ago, the dollar was worth a full euro.

The dollar also plunged anew against the British pound, the Japanese yen and the Swiss franc, among other currencies.

Some analysts said the dollar’s steep slide in recent months in part reflects foreign investors’ ebbing confidence in the U.S. economy, as the housing market bust has worsened and some of the nation’s most important financial institutions have been battered by huge losses on home loans.

“Any currency is a kind of a report card on the country,” said Brian Gendreau, strategist at ING Investment Management in New York.

The Federal Reserve, under Chairman Ben S. Bernanke, has been trying to bolster the financial system with the central bank’s most potent tool: cuts in short-term interest rates.

The Fed began lowering some rates in mid-August and followed that with cuts in its benchmark federal funds rate on Sept. 18 and Oct. 31, the first reductions in four years.

The stock market rallied after the large September rate cut, lifting the Dow index to a record high of 14,164.53 on Oct. 9.

Since then, however, the market has struggled. The Fed’s attempts to soothe investors’ concerns about the financial system have been offset by the massive mortgage-related losses that firms including Citigroup Inc. and Merrill Lynch & Co. have reported.

“The foundation of the U.S. is its capital markets, and we have the biggest players in the capital markets making terrible mistakes in their assessments of risks,” said Peter Morici, an economist and business professor at the University of Maryland.

Of course, lower interest rates take time to work their way through the financial system. No one on Wall Street expected the Fed’s moves to be an immediate tonic for the mortgage market, which is racked with fear of ever-rising defaults.

“The Fed can reduce the panic, but it can’t eliminate the problems,” said Alexander Paris, an economist at Barrington Research Associates in Chicago. “They have to work themselves out.”

The risk is that the central bank may be losing the race to get ahead of threats to the economy that could drive it into a severe downturn, some analysts say.

The confidence of U.S. consumers and executives has slumped in recent months, national surveys show. Waning faith in the economy can make a downturn a self-fulfilling prophecy if people and businesses begin to cut back their spending because they aren’t sure what’s ahead.

Record oil prices also threaten the economic outlook. Oil traded at a record high of $98.62 a barrel Wednesday in New York before closing at $96.37, off 33 cents for the day.

Some economists say the surge in oil prices partly stems from the dollar’s ongoing plunge. Because oil is priced in dollars worldwide, oil exporters in effect get less for their crude as the U.S. currency weakens -- unless the price rises.

“If they’re paid in dollars, their standard of living is eroding,” said Paul Kasriel, an economist at Northern Trust Co. in Chicago.

And it isn’t just oil exporters who have lost respect for the dollar. In one measure of the currency’s tarnished image around the world, a Brazilian magazine reported this week that 27-year-old supermodel Gisele Bundchen has begun insisting on being paid for her services in currencies other than the dollar.

The falling greenback does have beneficial effects. It makes U.S. products less expensive for foreign buyers. That has helped fuel a sharp rise in American exports over the last year, propping up the economy.

What many analysts have long feared, however, is that the dollar will begin to fall so quickly that it destabilizes the global financial system by triggering a rush to sell U.S. assets.

A dollar panic also could make it impossible for the Federal Reserve to further reduce interest rates to help the domestic economy, because lower rates make returns on U.S. fixed-income securities even less attractive to foreigners compared with what they can get abroad.

For the U.S. economy, “that is checkmate -- when the Fed can’t come to the rescue,” Kasriel said.

Bernanke may be grilled on this question today when he testifies before Congress’ Joint Economic Committee.

Many on Wall Street say investors shouldn’t get too gloomy. They note that major stock indexes have been volatile in recent weeks but still are above their mid-August lows. Year to date, the Dow is up 6.7%.

What’s more, they note, the economy isn’t showing signs of falling off a cliff. A net 166,000 jobs were created in October, the government said last week, exceeding most analysts’ expectations.

On Wednesday, President William Poole of the Federal Reserve Bank of St. Louis said the central bank stood ready to lower interest rates further if the economy deteriorated.

“It’s easy to imagine a scenario in which a rate cut would become a compelling next step,” Poole told reporters after a speech in Milwaukee.

Even so, he warned that Wall Street “should not anticipate” a rate cut at the Fed’s next meeting, scheduled for Dec. 11.

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tom.petruno@latimes.com

walter.hamilton@latimes.com

Petruno reported from Los Angeles and Hamilton reported from New York.