House Kills the Bailout Plan and the US Dollar

The rejection of the $700B bailout plan by the House of Representatives came completely out of the left field, driving a knife through both US equities and the US dollar. For the Bush Administration, it certainly feels like they are moving one step forward and taking two steps back but the severity of the financial crisis makes it absolutely necessary for Washington to put economics ahead of politics. Although traders were initially dissatisfied with Congress’ approval of Paulson’s plan, they were counting on a bailout. The combination of a huge liquidity injection by the Federal Reserve today and the hope that the bailout plan would move forward kept stocks from falling further. However those efforts and the sleepless weekend of debates turned out to be futile after the House rejected the bailout bill. For fairness, there was no was guarantee that Paulson’s plan would have helped average Americans, but at least it could have brought some stability to the financial markets. Unfortunately it is now back to the drawing board for Paulson who has to meet with Bush, Bernanke and Congress to discuss their next steps. Volatility in the financial markets benefits no one especially as more than $1 Trillion in market value has been wiped out from US stocks today. The VIX, which measures equity market volatility shot to the highest level in 6 years while gold prices jumped 3.8 percent. LIBOR rates have also skyrocketed while the TED spread continued to widen indicating that as a result of the House’s rejection of the bill, investors both domestically and internationally have become more risk averse. For those that are willing to part with their cash, they are demanding a high premium.

Dow 10,000 Could Mean 100 USD/JPY

dow092908 The Dow Jones Industrial Average closed down more than 770 points while the S&P500 dropped more than 8 percent. This is the largest single day drop in the Dow ever and the largest percentage decline in the S&P500 in 20 years. We have long argued that if the Dow hit 10,000, USD/JPY could fall to 100. That correlation remains intact today as the plunge in US equities drags USD/JPY towards 104.00. In the September 19th edition of the Daily Currency Focus, we argued that the US dollar could fall by another 5 percent. At that time, USD/JPY was trading at 107.40 and to many people a 5 percent move lower, which is the equivalent of 530 pips seemed like a farfetched possibility. However since then the dollar has already fallen close more than 300 pips, making a move towards 102 within reach. With the US stock market plunging and the US government looking to raise the national debt, in addition to hammering out the bailout plan, the Bush Administration will have to work extra hard to reassure foreign investors.

Gold Becomes a Hedge for Inflation and the US Economy

Now more than ever, the US needs to rely on foreign funding. If Central Banks and Sovereign Wealth Funds around the world start to lose confidence in the US financial markets or the US government, we could be looking at a complete freeze in lending that expands beyond the banking sector. According to an article in the Wall Street Journal, central banks are already loading up on gold as European central banks cut their sales to the lowest level in almost 10 years. Gold prices are up more than $35 an ounce today as a hedge for inflation and a hedge for the US economy. Everyone is starting to realize that commodities are the only assets that have no counterparty or credit risk. Gold prices first jumped on inflation fears after the Federal Reserve’s liquidity injections this morning. Having more than doubled their swap limits from $290B to $620B, the Fed is trying to tell the market that they are serious about providing liquidity and given today’s sharp volatility, they will continue to do aggressively in the coming days.

TARP Drama Gets More Dramatic – Time to Play Defensive

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Does Paulson’s TARP = TRAP?

For the second day in a row, Federal Reserve Chairman Ben Bernanke and US Treasury Secretary Paulson pleaded to the power players of Washington to pass their request for $700 Billion to implement their Troubled Asset Relief Program (TARP). However if we move the letters around a bit, TARP becomes TRAP and that is exactly how many investment managers, economists, politicians and average Americans view the plan. They are afraid that this is a trap for US taxpayers because they may be paying for a bailout that benefits the private and not public sector. Bernanke argues that a failure of the private sector would have “grave” consequences for the public sector, which is true and Paulson has finally agreed to accept limits on executive pay under the bailout plan. Yet, today’s price action in US stocks and the US dollar suggest that some investors are holding out the hope that Paulson’s TARP does not become the trap that keeps Americans still paying for bailout many years to come.

LIBOR Rates Jump, TED Spread Widens

Other investors on the other hand are more skeptical. Three month LIBOR rates jumped 26 basis points to 3.47 percent, which is the highest level since January. The TED spread, which measures the difference between the interest rates of the 3 month LIBOR and the 3 month Treasury bill hit an intraday high of 311 basis points. Not only is this only the second time in 2 decades that the TED spread has gone above 300bp, but the premium is far above its pre-credit crunch levels of 20 to 30 basis points. The greater the TED spread, the greater the degree of risk aversion and the fear of default in the market. Therefore the jump in the LIBOR and the widening of the TED spread suggests that investors are still hoarding their cash and they are skeptical of whether the government’s efforts will actually restore stability in the financial markets and improve risk appetite.

Paulson’s Plan Could be a Lose-Lose for the US Dollar

Paulson Paulson’s plan is ultimately a lose-lose situation for the US dollar. If it is approved, it would cause a destruction of the US balance sheet by increasing the nation’s debt ceiling by 6.6 percent to $11.315 trillion. If it is not approved or if Paulson and Bernanke only get a trimmed down version of the plan, they would have to go back to the drawing board to come up with other solutions to unclog the mess. If we end up being between rescue plans, the uncertainty would weigh on the US dollar. Therefore I still believe that the US dollar could fall another 5 percent over the next few months.

Home Sales, Durable Goods and President Bush

house Existing home sales dropped by 2.2 percent last month while mortgage applications plunged by 10.6 percent, the largest decline since July. The ongoing turmoil in the financial markets has made it increasingly difficult for even people with money to buy a home to secure loans. House prices continue to fall with the median price declining 9.5 percent from last August, causing more homeowners to pull their houses off market. The inventory of unsold homes dropped 7 percent, which was the largest decline since December 2006. In times of strong growth, a reduction of inventory may be good because it could suggest that demand is strong, but in times of weak growth, it suggests instead that homeowners are giving up on selling their homes now. Durable goods, jobless claims and new home sales are due for release Thursday morning. We continue to expect economic data to confirm that the US economy is weakening. President Bush will also be giving a nationally televised address on the financial crisis on tonight. Although we do not expect any groundbreaking announcements, his comments could nonetheless be somewhat market moving for the US dollar.


Hurricane Premium Off the Table, What is the Impact on Growth

With Hurricane Gustav being downgraded to a tropical depression, the Hurricane Premium is off the table. Oil prices have plunged more than $10 a barrel since Friday with $100 a barrel now within striking distance. The rally in the US dollar is a direct result of the fall in oil prices. Since the beginning of the year, we have seen a 70 percent correlation in the price of the EUR/USD and crude.

The last time crude prices were at these levels was back in April. Falling crude prices has widespread benefits for the US economy. Like the correlation between oil and the EUR/USD, the correlation between annualized US CPI growth and oil prices has been more than 70 percent since 2006. This supports our belief that inflation going forward will ease. Today’s manufacturing ISM number is the first example of that. The prices paid component of ISM dropped for the second month in a row with the index now at the lowest level since February.


How Does Oil Impact Growth?

According to a study by the International Energy Agency a few years ago, a sustained $10 a barrel rise in oil prices reduces world GDP by at least 0.5 percent, other things being equal. Since the middle of July, oil prices have fallen approximately $40 a barrel, which means that the recent drop in oil prices could add as much as 2 percent to GDP. We do not expect the reverse contribution to be as great, but if oil prices remain at current levels or continue to fall, a 1 percent contribution to GDP is certainly reasonable.

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Oil Prices Could Hit $130 a Barrel

It’s a super busy day, so I haven’t gotten a chance to really blog about the markets. However so far oil prices are down $6 a barrel – for $13 over the past 2 trading days.

I wrote this post on How Far Could Oil Prices Fall? last week, which is quite applicable to today’s price action:

By now, everyone should realize that oil prices are determining monetary policy. This is true for the US as well as other central banks around the world. Central bankers have been very worried about price pressures and we know that most of the pressure comes from oil.

Oil prices are impacting not only monetary policy, but also stocks and the US dollar. The rebound in oil prices today and geopolitical tensions are driving the US dollar lower. Iran reportedly test fired 9 missiles in the Persian Gulf and according to the Associated Press, the missiles could reach Israel, Turkey, the Arabian peninsula, Afghanistan and Pakistan.

These geopolitical tensions will probably ease as Iran’s test fires prove to be nothing than muscle-flexing. At that time, oil prices will continue to fall. Speculators are driving the move in oil prices and if the selling exacerbates, these traders will be quick to abandon their long positions. Yesterday’s drop in crude was the largest since 1991, but we could see another $10 drop before prices hit a bottom.

As indicated in the following oil chart, prices started to really take off in 2006. The move however has not been vertical. Between 2005 and 2008 there have been many corrections and on average, the corrections have ranged between 10 to 15 percent.

The second chart gives a closer look of the price action in oil over the past year. Even though crude hit an all time high of $145.85 on July 3rd, that was not before a series of retracements.

Therefore another $10 drop in oil prices is feasible even if oil remains within an overall uptrend and that would be bullish for the US dollar (Q3 Outlook for US Dollar).

Source: Bloomberg

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In the Financial Papers: Today’s Top Forex News 07.10.08

kathysmallHere is the “In the Financial Papers Radio Broadcast” (Length: 7:48 minutes). The player should load automatically. Please let me know if you like it. Contact Kathy

Read my Daily report on

In the Financial Papers:


Podcast Covers:
Jobless Claims Drop Distorted by Seasonality
Australian Employment Numbers Much Stronger than Expected
Bank of England Leaves Interest Rates Unchanged
Ex BoE Goodhart Says UK Faces Quite a Recession, Forcing Rate Cut
S&P 500 Ventures into Bear Territory
Canada and Mexico: Stock Markets Holding Up In Face of US Sell-off
What Would the Fed do If Fannie or Freddie Failed?
BNP Outlook for Australian and New Zealand Dollars

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