A Forex View From Afar

The need for a bailout

The House of Representatives might have vetoed the Treasury’s plan to bailout financial institutions, but the market still sees a very strong need for a rescue package.

The market’s response as the news of the vote unwrapped, confirms that investor’s confidence is close to zero. Global equity markets tumbled the most in 21 years, while the major U.S. indexes posted some record declines.
If someone wants to look for any further evidence that the financial system needs a serious bailout plan, then just look at the number of banks recently bankrupted or were forced to “sell themselves” on both sides of the pond. Lehman, Merrill, AIG, Washington Mutual, Wachovia in the U.S and Fortis, Dexia and Hypo Real Estate in Europe are just the latest banks that can be added to the of credit crunch casualty list.

A new bailout plan with explanation and serious clarification on what the Treasury will do with the cash it receives might give it the potential it needs to pass the vote. However, till then, who can vote for a blank check with $700 billion on it that not too many know its clear purpose or effects?

Reports are just starting to appear with the effects of the credit-crunch over the real economy. Tougher access to liquidity and credit, weak consumption and small owners complaining about the business environment are just to name a few. If banks will not start to do what they are intended to do, lend, then this will be just the beginning as the whole economy is torn apart.

An alternative to the bailout plan would be for the Treasury to bankrupt every possible bank, until only one stands. Since Mr. Paulson has strong relationships with Goldman Sachs, it will not be hard to imagine which would be the last one standing. Moreover, since now they receive deposits, who really needs more than one bank??? Oh, let’s not forget that the U.S. still needs Bank of China to support its debt, but that would be another story.

To finish this article, who knows what a Wall Street bank is now? The answer is simple: a bank is nothing more than a future government entity.

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Wall Street Bailout and the Real Economy

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Trading the Canadian Dollar

The Cad has a unique trading style, moving only one third of the trading day, during the U.S. session. For the rest of the time, the pair tends to hover around a price level, be it the neutral pivot point, a moving average or a support/resistance level. Lately, however, the Cad has started to move during the overnight sessions as well, but the volume continues to be low and insignificant.

The daily chart shows little signs of dollar strength, even though the dollar has posted strong gains against its European counter-parts. This suggests the pair may not have too much room to run on the upside. The 1.0500 area may be a key resistance level in the future, as it has in the past, and long orders should come after this level is broken.

Regarding future short positions, the cad will first have to break below the 1.0300 level, which is an important swing point. At this level, the resistance area (which has now become support) held for over 9 months in which the cad was unable to close above. Having crude oil, the commodity that back’s the cad valuation, holding around the $100 level, we may see some additional tests below the 1.0300 level. The intra-day pattern of trading shows that it is better to avoid any short-term trades around the U.S. session open, when we often see a wave of orders hit the market.

This week, the only important news release coming out of Canada will be the GDP read for the third quarter. The market is expecting a 0.2% read, while the second quarter GDP was released at 0.1%. A read that deviates from market expectations will certainly move the market and test the closest support or resistance, depending on the news release.

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Wall of Shame The Bailout Plan

The bailout plan is the hottest topic around, let us examine some of the plan’s unique characteristics:

• The plan will require a blank check with $700 billion on it, minimum
• Although the plan is just steps away from being voted, no one can say for sure what it does or how it will be implemented
• The agency in charge of supervising the plan is still unknown.
• The plan presumes the toxic debt will be taken from banks’ balance sheets. It’s still not sure how it will be priced
• Toxic debt = packages of mortgage loans which are in a default phase. Most securities had been downgraded from investment grade to junk. This looks more like investors trying to scrap them, rather than the liquidity crisis that the Treasury claims.
• If the bad debt gets overpriced U.S. taxpayers will support the losses.
• If the bad debt is under-priced or priced at the current market value, it will not help the institutions who may as well offset it at fair value now. Banks can simply write down the bed debt and the same effect will emerge.
• The main reason behind the sub-prime crisis was the high default rates among homeowners and falling house prices. Injecting huge amount of cash into the financial system will not reduce mortgage rates, nor help interbank liquidity that impacts the taxpayer who is back-stopping the package. This looks like trying to cure the symptoms rather than the disease.
• Mr. Paulson is asking for full immunity when implementing the bailouts. To some, this says a lot, and to most it says it all. This smells.
• The plan has alternative names too: “The Swedish Solution”, “The Hanky Dumpty sat on the Wall (Street)”, “Bail-me-out Mae”
• The plan has no provision for financial officers of the failing business models to re-pay into the $700B any of the bonus checks issued since June 2007 downgrades of toxic debt, that is something maybe to consider. Check issued to “The U.S. Taxpayer” will start to cover things by all of those courageous enough to do the right thing and balance the investor’s book a little. The taxpayer foots the damage bill, as well as having their own investments stripped bare. The market’s job is to take the maximum amount of money from the maximum amount of people in the minimum amount of time. Well done on getting that done, but this really is turning into a Hall of Shame.

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Looking at the inter-banking liquidity

Usually, when a bank wants to make a loan for liquidity needs it has two options: either borrow money from the central-bank, through the open market operations, or call another bank to lend money at the LIBOR rate. The London Inter-bank Offered Rate or LIBOR is the reference rate at which banks lend money each other.

A major distinction between those two would be that banks need collateral in order to access money from the central bank, while there is no such need when accessing funds from a fellow bank. This would imply that money accessed through the LIBOR rate, would be more expensive (a higher interest rate) because the loans are not secured.

In order to measure the liquidity from the inter-banking environment, investors use the Libor-OIS spread. The index measures the spread between the costs of accessing money throughout the LIBOR rate on a three month loan and the overnight rate at which banks would access funds from the central bank. Usually, the spread is just a few basis points, less than 10 (or 0.1%), however, today the spread reached a massive 166 basis points (or 1.66%). This is the highest spread recorded since 2001, showing that there is a massive lack of liquidity.

The other alternative for a bank would be to access money from the local central bank. The recent open market operations held by the SNB and ECB showed that this is mainly what banks do. The ECB auctioned $25 billion yesterday with a maturity of one month, and received bids valued at $110. The average rate at which banks accessed the $25 billion was 3.75%, while the LIBOR rate with one-month maturity reached 3.20%. This shows that banks decided to have a rush at the central bank’s offer, despite funds from private banks being much cheaper. In normal market conditions (which these are not), the LIBOR would be bigger than the open market’s interest rate, since a LIBOR loan implies additional risk, requiring a bigger premium.

This does not have a direct effect over the currency charts, but it shows that banks are not lending to each other, fearing that bankruptcies may continue. Put head to head, it shows the financial system is a long way from recovering. As such, trade desksmay not be willing to take risk onto their balance sheets, meaning the high yielders (the plural from yielder) and the yen will just hover around the support/resistance levels on the charts. Assuming, of course, that no news hits the wires that cause a different reaction.

Quoting from an old London high street joke, the LIBOR is the rate at which bank’s do not lend to each other.

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Learning from the past

The Treasury proposal of a huge infusion of capital into the financial system and bank’s balance sheets had already been used by other countries, although the outcome was not always so bright. The plan proposed by Mr. Paulson is similar to the one used in Sweden the 1990’s, as we reported this week, in helping banks deal with the bad debt. However, the Swedish had a different approach to this solution; in exchange for the capital infusion Sweden asked for equity. However, Mr. Paulson’s plan only asks for the bad assets and nothing more in return.

The problem is how exactly these toxic papers will be valued. If they are overpriced, the taxpayers will suffer a huge loss, since the Treasury will pay for valueless paper, with little chance of forward redemption. If they are underpriced, or the Treasury pays the same price as their current real value, it won’t solve anything since banks can achieve a similar outcome just by writing-down the bad debt. From here, this appears that the U.S. proposal is loss-loss situation to the taxpayer, and maybe therefore to the Usd.

Even with the “Swedish solution” applied to the U.S. problem, the real economy may still have a hard time ahead. The Swedish economy recovered some 4 years later, in a period when unemployment rose from 2.1% to an incredible 19.9%. In Norway, a neighboring country that faced the same problem, unemployment also rose at a strong pace in the following years, but not as much as in Sweden.

Japan also had to deal with a huge asset bubble in the early 1990’s. The Japanese authorities had chosen a similar solution, injecting huge amounts of capital into the economy. The strategy was called “quantitative easing” and had no real effect over the economy. Actually, the only effect (counter-effect more likely) is that the Japanese economy has never fully recovered from the asset bubble, not even to this day. The Nikkei topped out around 40,000, dropped to around 7,000, and today trades at 12,000. Cash infusions do not always work, and in some cases just prolong the crippling effects of what would otherwise have been a painful but warranted natural reduction of those unable to perform in a changing financial arena.

The mountain of U.S. debt needs servicing, and this may be the cost of reckless borrowing. The U.S. economic outlook may not as bad as that of Sweden or Japan, just yet, but things are delicately balanced between imparting a reasoned argument to mortgage the future and the huge financial liability to the U.S. taxpayer of this creating another debt mountain that will never get repaid. The U.S. struggles with current debt payments as it is, managing to make the minimum payment when servicing its overseas commitment of repaying existing debt. A rise in unemployment and a drop in output are still expected over the next quarters, and that is not the environment that will make the dollar bulls feel warm and fuzzy, nor overseas wealth funds swoon at that thought of U.S. based assets dominating their books.

The U.S. is the economy that pulls the levers on the global scale, but we have asked our-self time and again recently whether 'The Global Player' may not become just another one of the 'Group of Global Players' in quick time. The BRIC (Brazil, Russia, India and China) group is watching the outcome closely. The BRIC’s are seen to be more than capable of forming an economic bloc, similar to the European Union, and have been studied to such a degree that the BRIC’s by 2050 could have a wealth and global dominance that eclipses the current Global Players.

The King of Currency has some suitors, and the World’s currency may now have to see some backing from the U.S. economic infrastructure being re-built on firmer foundations than the last re-balance, if the Usd is not to come under some valuation pressure.

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