U.S. MARKETS OFFER GLIMPSE OF VOLCKER NIGHTMARE Today's turmoil in the U.S. Financial markets, with bond and stock prices tumbling in the dollar's wake, is evidence of a major shift in investor psychology that is likely to spell more turbulence ahead, economists said. For two years, the markets had hailed the dollar's decline as the cure-all for the U.S. Trade deficit. Interest rates fell sharply and Wall Street became a one-way street, up. But that confidence is now cracking as the financial markets suddenly believe Fed chairman Paul Volcker's often-repeated warnings about the risks of a dollar collapse. "Volcker's been saying for a long time that a dollar freefall would be extremely dangerous - now he's got it," said David Jones, economist at Aubrey G. Lanston and Co Inc. The dollar fell below 144 yen today for the first time in 40 years as the Group of Seven finance ministers in Washington failed to convince the foreign exchange market that they have a credible strategy for redressing global trade imbalances, short of further depreciation of the dollar. Bonds suffered their biggest one-day drop in months amid worries that the dollar's slide will rekindle inflation, scare away foreign investors and force the Fed to tighten credit. The inflationary fears boosted gold bullion by more than 12 dlrs to a 1987 high of 432.20/70 dlrs an ounce, while the spike in interest rates pulled the Dow Jones Industrial Average down by 33 points to 2339. Norman Robertson, Mellon Bank chief economist, called the markets' instability frightening. He believes economic fundamentals do not justify the bearishness but said that "once you start the ball rolling it's difficult to stop." "There's a stark possibility that you could get a destabilizing drop in the dollar that forces up interest rates and drives us into recession. The markets are in a panic." Stephen Marris of the Institute for International Economics in Washington, has been warning for a long time that the controlled decline of the dollar since peaks of 3.47 marks and 264 yen in February 1985 could turn into a nightmare. "We're still more or less on track for a hard landing... But the agony may be fairly drawn out," Marris told Reuters. Marris does not expect the crisis to peak until later this year, but he warned that the situation is so fragile that it would take very little to touch off what he calls the second phase of the hard landing, whereby a loss of confidence in the dollar pushes up interest rates and leads to a recession. The stock market's reaction today and its sharp drop on March 30 shows how the loss of confidence could come about. The fact that it has not happened yet is consistent with historical experience, which teaches that domestic markets are not affected until a currency is in the final stages of its decline, Marris said. He has forecast a drop to about 125 yen. Marris felt that a major impetus for the dollar's latest weakness was the loss of credibility that central banks suffered when they failed to prevent the dollar from falling below 150 yen, the floor that the market believes was set as part of the G-7 Paris agreement in February. Robertson at Mellon, by contrast, said the loss of confidence was triggered last week when Washington announced plans to slap 300 mln dlrs of tariffs on Japanese electronic imports, raising the specter of a debilitating trade war. Many economists believe that long-run stability will not return to the markets until the root cause of the trade gap is addressed - excessive consumption in the U.S., Reflected in the massive budget deficit. But in the short term, given the failure of the G-7 and of central bank intervention, some feel that the Fed will have no choice but to tighten credit to restore faith in the dollar. "The only thing that will stop the dollar falling is a substantial increase in the discount rate and a corresponding cut abroad, at least by Japan," said Lanston's Jones. Marris expects the Fed to act quickly to raise interest rates, even at the risk of increasing the debt burden for American farmers, Latin American governments and others. But Robert Giordano, chief economist at Goldman Sachs and Co, scoffed at the notion. "It's ridiculous to think the Federal Reserve will raise interest rates when the dollar is weak against just one currency. This is yen strength, not dollar weakness," he said. Giordano said the market was ignoring the progress being made toward reducing the U.S. Budget deficit. "We're going to have one of the biggest reductions in the budget deficit relative to GNP in history this year, and nobody cares," he said, noting that only the deficit cut in 1968-69 will have been greater. He said he does not expect the dollar to collapse and thinks interest rates are likely to fall back later this year. But for now, market psychology has changed so abruptly that a further drop in the bond market cannot be ruled out. "Put on your helmets," Giordano said.