TIC Report Explains Dollar Rally – Top 5 Owners of US Treasuries

Despite the turmoil in the US financial markets, foreign demand for US securities remain robust, particularly since the Treasury’s International Capital flow report was for September, the month that Lehman collapsed.

TIC Report Explains Dollar Rally

Demand was particularly strong for US Treasuries and equities but foreigners dumped corporate bonds on the fear of default risk. As a testament to China’s rising economic power, they have now surpassed Japan as the largest holder of US debt. In September, increased repatriation led to a net sale of US securities by the Japanese while China accumulated a growing amount of US securities for the third consecutive month. The increase in foreign holdings of US debt helps to explains the dollar’s recent rally because despite higher issuance, demand for US Treasuries remains voracious.

Top 5 Owners of US Treasury Securities

Watch out for Paulson and Bernanke

The strong TIC report and the positive news from the tech sector is helping to fuel a recovery in Dow futures, which is driving the US dollar and Japanese Yen lower. We could see a recovery in carry trades today as long as Bernanke and Paulson don’t rain on the party when they testify on the government’s implementation of the $700B bailout plan before the House Financial Services Committee. This is a big risk since Paulson indicated yesterday that he will be leaving the clean up job for the new Administration. He does not plan on requesting the second half of the $700B bailout plan to leave firepower for Obama’s team. If Paulson continues to wash his hands of this mess, the market may begin to sell off once again, driving carry trades lower on the fear that nothing new will be implemented until Obama takes office. With 8 weeks to go before Bush leaves office, the current Administration is more focused on wrapping things up than starting new initiatives.

Source: Wall Street Journal

Source: Wall Street Journal

Higher Core Prices Will Not Stop the Fed From Easing Rates in December
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Stocks Rally and Currencies Recover: Is this the Bottom?

The case for a bounce in equities this week was strong following the Lehman CDS Auction and the possibility of new measures from the G7 and G20 nations in Washington this weekend. New guarantees and a host of other announcements have helped to stabilize the financial markets and ease the credit crisis, but is this enough or are we simply seeing a light volume Columbus Day rally in US equities?

Banks and money markets are closed today, which means that we have yet to see the full reaction to this weekend’s announcements, but there is a good chance that this is a near term bottom that could lead to a move back above 9500 in the Dow as investors come in to scoop up stocks at fire sale prices.

Many of the liquidity problems in the financial markets have been addressed by the unified response from the G7 nations. The timing is also right because equities and carry trades have become so oversold leading investors to look for a reason to buy. Sentiment is extremely important these days and we have seen market sentiment shift from skepticism to hope, which should lead to a reversal in the strength in the US dollar and Japanese Yen. From the unlimited dollar funding to interbank loan guarantees, the efforts of nations around the world may be finally working.

In order for this to be the long term bottom in equities, two important hurdles need to be overcome – the Oct 21 settlement of Lehman’s Credit Default Swaps and the Nov 7 settlement of WaMu’s CDS. As counterparty A forks up payment to counterparty B for the protection of a Lehman default, bankruptcies is a strong possibility as those who fall into the counterparty A group fail to come up with the money. If there are no major bankruptcies that forces the US government to come up with another $100B to recapitalize an ailing financial institution, then the worst may be over (Here a great article on Who’s on the hook for the Lehman CDS mess).

Eventually everyone does the right thing and this is the step in the right direction for all of the major world economies. For the currency market, this means a correction in the US dollar and the Japanese Yen, but a recovery for carry trades and the Euro.

Now let’s get a little bit more specific on who announced what this weekend:
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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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The 3Ps Push the Dollar Higher

The US dollar continues to recover this morning on the aftermath of the 3Ps – Paulson, Plosser and price of oil. Oil prices are trading on the $125 handle and since last Monday they have fallen more than 14 percent. If oil prices reach $100 a barrel, half of the Fed’s problems would be solved; Consumers would become more liberal with their spending while businesses would become more optimistic.

As for Plosser and Paulson, the Fed President called for interest rates to be increased sooner rather than later, reminding the traders that the Fed still has their eyes on a rate hike.

US Treasury Secretary Paulson was confident that Congress would approve his housing rescue plan this week and so far they are moving forward as planned, with some adjustments.

Paulson proposed increasing Fannie and Freddie’s credit line with the Treasury and permission to buy stock in the mortgage giants. The deal that is likely to come out of the House and Senate would permit the government to inject billions of dollars in Fannie and Freddie and to insure up to $300B in refinanced mortgages. The plan is up for vote at the House of Representatives today.

Meanwhile EUR/JPY has hit another record high and is trading within a whisker of 170. Here’s my explanation of why EUR/JPY has performed so well over the next few months.

Finally, keep an eye on the Beige Book report of business activity which will tell us how the US economy is faring.

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3 Important People Want the Dollar to Rise

The Clear Message from the Bush Administration

bernanke Last Tuesday, Federal Reserve Chairman Ben Bernanke breaks from tradition and talked about currencies. He drew links between the weaker dollar and higher import costs and consumer price inflation. His cohorts including Fed President Geithner confirmed that the central bank is paying “very close attention” to the value of the dollar. Last night, he reminded the markets night that inflation is the central bank’s top priority.

paulson On Monday, US Treasury Secretary Paulson said that he would not rule out any policy tool including currency intervention.

bush Last night, on Airforce One, President Bush told The Times of London that “we want the dollar to strengthen”

Even though I do not believe that the Bush Administration will resort to currency intervention, Washington is getting very concerned about the dollar and clearly, want it to rise.

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