A Forex View From Afar

Is the worst over yet?

Written by A Forex View From Afar on Wednesday, June 18, 2008

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Is the worst over yet? The answer probably depends on what type of persons are you asking, optimist or pessimist, and more than ever it depends on what positions they have in the market.

For RBS strategist it seems the answer to this question is a big 'no'. Inflation will cripple the capital markets in the following months, especially the credit market, they say;

"The significant bearish repricing I expect to see during August/September/October will be driven by massive negative revisions to growth and stubbornly high inflation, leading to earnings deterioration, massive negative revisions to earning expectations for H2 ‘08 and deep into 2009, weaker and weaker credit metrics, higher and higher defaults and ongoing problems/de-leveraging in the financial sector.

Bob Janjuah, the RBS credit strategist"

It seems that other analysts share this view, including Morgan Stanley’s team, although RBS estimates are much darker story than most of the other banks. In this doom and gloom situation the S&P rating agency looks more then ever ready to give a helping hand by downgrading large portions of assets;

"330 US CDOs put on credit watch negative
80 second lien RMBS cut to ‘D’
65 Alt-A RMBS ratings cut
28 European synthetic CDOs on credit watch negative"

We should add to the above list $200bn of CDOs that just hit default. Hey, was it not the S&P who rated them initially as AAA quality?

The main condition for the RBS scenario is inflation getting out of central bank’s control. I am not sure at this time how long inflation can last, since all major central banks look ready to tackle higher prices. The ECB is ready to raise rates and probably will, the Fed have already changed their view (at least in their jawboning statements), the Bank of Canada did not cut (a move that was as good as a raise, because it was against expectations), the same for Bank of England, even with the UK’s economic landscape being in a continued downturn. At least we have found out that central banks are aware of inflation, and therefore have to accept currency appreciation if they do raise rates.

How much can CBs actually increase rates in their inflation fight? A quick look at the Fed says not too much. Just a couple of months ago they were slashing interest rates in inter-meetings, and now they are preparing to rise? Something does not sound right. The rate cuts still haven’t reached the economy and the Fed is already reversing them, strange moves, not a lot of credibility, and not really a consistent environment to put money into U.S. Treasuries.

Then we have the ECB which missed the inflation target by a massive 1.7%, from 2% to 3.7%, which is almost 80% off the target. How much can they actually raise, when large parts of the old continent is reeling from the strong euro, and has a population that is very reluctant to spend or borrow. Not to much I’d say.

The I word, inflation, is all that we will hear for a while now, and since inflation and inflation expectations play a major role in currency valuation, not to speak about the jawboning from the press conferences (see ECB), that is what the markets will be trading. Next week the FOMC members will be sending the dollar on a roller coaster ride as the expectancy of higher rates sometime this year builds, and as we all know the markets prefer to buy the rumor than they do buy the news. So Fed, the dollar valuations are all yours, you have blown it up higher with hot air, are you going to follow through, or watch your 'Strong Dollar' policy deflate like an old balloon?

Sources:
FT: Structured credit watch
FT: CDS report: “The very nasty period is soon to be upon us — be prepared”