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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Oil Continues to Drive the Dollar

The eyes of everyone from investment managers to stock and currency traders were glued to testimony of the 3 biggest players in the latest financial crisis. US Treasury Secretary Paulson, Federal Reserve Chairman Ben Bernanke and SEC Chairman Cox urged the Senate Banking Committee to approve their request for $700B of taxpayer money. Instead of calming the markets, Paulson and Bernanke spent their time warning of the doomsday scenario should the Senators fail to approve their plan. As a result, stocks came under severe selling pressure. Volatility has been vicious in the financial markets today but the one thing that has remained relatively consistent is dollar strength. The greenback traded higher against every major currency. On Monday, the dollar’s weakness was triggered by the sharp rally in oil prices and today, the retracement is leading to a recovery in the US dollar. Since the beginning of the year, the EUR/USD has had a close 70 percent correlation with oil prices. Over the past 3 months, that correlation has become greater than 90 percent.

From Main Street to Washington, No One is Happy with Paulson’s Plan

Based upon the criticism by the Senators, the backlash from economists, commentators and average Americans, no one is happy with Paulson’s plan. The big question on Main Street is whether Paulson is putting the private interest ahead of the public. This is certainty a heavy debate and one that we will not take up in this column. Instead, we acknowledge the fact that no other viable solutions have been offered and instead Paulson has simply relented to more oversight. This lack of confidence or clarity in Paulson’s plan is a big reason why the US dollar could fall by another 5 percent. Like banks, investors from around the world are pulling their money out of high risk investments and hoarding their cash. According to The Independent, hedge funds are suffering mass redemptions. Foreign investors continue to lose confidence in dollar denominated investments, which is reflected in the sell-off in the stock market and rally in US Treasuries. For currency traders, this means that the US dollar is headed lower.

The Problem is Counterparty Risk

Paulson’s argument is that by freeing up capital for the banks, they can resume making loans for individuals and businesses. However the problem that lenders face is not necessarily a lack of cash, but the fear of couit’sitnterparty risk. The only encouraging thing that came out of the statement was a peculiar comment from Fed Chairman Ben Bernanke. Rather than stick to his prepared testimony, Bernanke spent his time talking about buying assets at their value if held to maturity over buying them at fire sale prices. If this is what they actually do, we could see banks revise up their write-downs. Unfortunately this is another band-aid that masks some of the troubles in the financial crisis and not a new solution aimed at boosting lending, reducing risk aversion or stimulating growth. Unless these problems are tackled head on, the US economy could be in for more trouble.

More Signs that Mr. Scrooge is Coming this Holiday Season

The Richmond Fed manufacturing Index and the report on house prices were both weaker than expected, but the big disappointment came from the National Retail Federation’s warning that spending this holiday season could be the slowest in 6 years. More consumers may be forced to think like Mr. Scrooge which will lead to weaker growth and slower hiring. Existing home sales are due for release on Wednesday. We expect sales to continue to slow because even if homeowners have money to buy, lenders are making it very difficult for them to take out a loan in excess of their down payment.

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US: Forget About a V-Shaped Recovery, Maybe a W or L

The volatility that we have seen in the currency, stock and bond markets this past week has not been for the faint of heart. The Dow Jones Industrial Average fell 500 points on Monday, but instead of continuing lower over the course of the week, it staged the biggest 2 day rally in 5 years. Three to four hundred point swings in the stock market have become the norm this week as surprises and disappointments from the US government keeps traders on their toes.

The current Administration has thrown everything but the kitchen sink at the markets and based upon the recovery that we have seen over the past 2 trading sessions, something has worked. The most powerful of which is probably the Securities and Exchange Commission’s temporary ban on short selling and the hope that Paulson and Bernanke will deliver a new groundbreaking rescue plan that will include a bail-out fund that sops up all of the troubled paper. This has forced a massive short squeeze that drove stocks up more than 750 points in 2 days. Although there could have also been some genuine buying, the rise in gold prices suggests that some investors are still nervous. With no details disclosed at his press conference on Friday, it will certainly be another long weekend for US Treasury Secretary Paulson.

Don’t Expect a V-Shaped Economic Recovery, Maybe a W or L

The main take away from the recent developments is that we will not see a V shaped economic recovery. According to the data released this past week, the housing market and the manufacturing sector are still in trouble. Durable goods, the final numbers for second quarter GDP, new and existing home sales are due for release in this coming week and we expect the data to confirm the weakness of the US economy. Layoffs will rise, consumer spending will slow and corporate profitability will decline for at least the next 3 to 6 months. A recovery usually comes in one of four forms – U, V, W or L. We believe that in the current case of the US economy, we will probably see a recovery that looks more like a W or an L.

Investment Banks: 3 Down, 2 to Go

Of the top 5 investments banks on Wall Street, 3 have disappeared this year – Merrill Lynch, Lehman Brothers and Bear Stearns. The last ones standing are Morgan Stanley and Goldman Sachs (Citigroup and JPMorgan are considered universal banks since they have commercial banking divisions). With Morgan in merger talks, there could end up only being one independent player left in the market. For banks to consolidate is not a surprise but their consolidation now is more of an act of desperation than anything else.

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Currency Forecasts for Q3

My team at DailyFX just published our third quarter currency market forecasts. Definitely worth a read:

EUR/USD (Link to Fundamental and Technical Outlook)
– Oil is Determining Fed Policy
– Federal Reserve: A Third Quarter Rate Hike?
– When Will the US Consumer Buckle?
– Labor Market: String of Job Losses Set to Continue
– The US Dollar At or Near a Bottom
– Euro Bye Bye Boom
– ECB Full Speed Ahead
– Risk of Recession Ahead?
– North – South Decoupling Continues
– EURUSD to Remain Contained Within its Range

USD/JPY (Link to Fundamental and Technical Outlook)
– Risk Appetite will Drive the Japanese Yen in the Second Half of 2008
– What Can we Expect out of Risk Appetite and the Carry Trade?
– Bank of Japan one of the few central banks not overly worried about inflation
– EURJPY Could Continue to Rise on Hawkish European Central Bank Rate Outlook (To be revised post-ECB)
– What to watch for in the Third Quarter for the Japanese Yen

GBP/USD (Link to Fundamental and Technical Outlook)
– The Bank of England Weighs the Risks
– A Slowing Economy…
– A Feeble Financial Sector…
– Rocketing Price Pressures Have Pushed Inflation Well Above Target…
– What Will The Bank of England Do?
– A New High in EUR/GBP?
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