Government Actions Cloud the USD Outlook

09/22/2008 12:00 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Oww! My head hurts. A lot has happened in the course of the past week, and like many in the market, I'm having some difficulty getting my head around what has happened and what it means going forward. The major news is clearly the US government plan to form a Resolution Trust Corporation (RTC)-like entity to absorb toxic MBS (mortgage backed securities) debt from financial firms' balance sheets. The focus here is on returning the US financial sector to some form of normalcy so it can resume supplying badly needed credit to the US economy, which is a good thing. Many details of the plan are yet to be revealed, not the least of which is the expected cost, which leaves many questions still open, and that is a bad thing. (For instance, how much more will banks need to write down when they off-load their troubled MBS debt, and what will that do to their capital reserves and ability to lend?) The details are expected to be ironed out over the weekend and in coming negotiations between Fed/Treasury/Congress next week, with a likely plan in place by the end of the week. In the meantime, I offer my preliminary thoughts on what recent developments mean for the USD and other currencies below.

The most recent effort by the US government to stabilize the financial sector, and by extension, the housing market and Main Street economy, likely represents a final turning point in the sub-prime credit crisis that began well over a year ago. Looking ahead, these are clearly positive developments for the US economy and reinforce the case that the US will be able to avoid a recession in the current soft patch. But the implementation and impact of such measures will take time, probably months at least, to be realized. In the short run, concerns over the explosion in US government liabilities that come with the RTC plan will likely weigh on USD sentiment. In the short run, the greenback looks to have further room to fall in what is now shaping up to be a USD correction lower. In EUR/USD, the upside looks to be in play while prices hold above 1.4390 on a daily closing basis, with that level marked by the 21-day moving average and the Kijun line from daily Ichimoku charts. The upside sees key resistance at 1.4580 from the base of the weekly Ichimoku cloud, and channel resistance from a possible bear flag above at 1.4680/700, making the high-1.46/low-1.47 area a zone to consider re-establishing EUR/USD short positions.

If we step back and look at economic fundamentals, however, the outlook for the USD arguably just got a lot better. Between the takeover of Fannie/Freddie and now the RTC solution, mortgage and consumer credit are likely to be greasing the economy's wheels in the near future. Congressional leaders are also set to put forth a second economic stimulus package that could provide an additional boost, especially in job creation, into the end of the year. In contrast, governments outside of the US have been considerably less active in taking steps to support economic growth, even though many of their economies are likely already in recession (UK, Eurozone, Japan, Canada, and NZ). Also, interest rate spreads have narrowed in favor of the USD to levels last seen when the USD peaked on Sept. 11, removing a minor interest rate disadvantage since then. The fundamentals will eventually re-assert themselves and we'll need to watch the data closely. However, whereas the USD was able to shrug off weak/disappointing data during its rebound since mid-July, it's now more likely to experience a more even-handed reaction (falling on weak data/recovering on better news) during this period of correction.

Risk Appetites Return, for the Moment

The most significant currency moves over the last two weeks took place in the JPY crosses, the proxy for risk seeking/aversion in FX. JPY crosses, like AUD/JPY and EUR/JPY, were pummeled lower as credit markets seized up and then rebounded as the latest, and hopefully final, US government initiative was announced. However, I am skeptical that this sudden return to risk-seeking behavior can be sustained. To say that the US or global outlooks remain uncertain would be a gross understatement. At the minimum, markets do not even have a handle on the large or fine print of the RTC bailout package yet, and the numbers being discussed are alarming, not inspiring. Commodity prices are also showing indications of risk aversion remaining elevated, so I would caution traders not to get carried away with carry trades from current levels (e.g. EUR/JPY at 155).

What Does the Fannie/Freddie Takeover Mean for the Dollar?

Government officials in the US enacted a few initiatives this week in an attempt to calm what was a tumultuous week for global markets. We highlight these measures below.

1) Planned government facility to rid banks of toxic mortgage securities From the scant details offered thus far, it seems the plan is basically for the US government to create a sort of super fund that will buy the distressed mortgage paper from the banks, effectively removing the toxic assets from their balance sheets. Little else is known in terms of the extent of write downs the participating banks will have to take upon the sale of such assets, or exactly what the government will do with the paper. One major brokerage recently sold most of its bad mortgage assets for roughly 20 cents on the dollar in an attempt to clean out its balance sheet, so there is definitely some precedent here in terms of pricing.

The ultimate cost of this bailout has been bandied about, with a plethora of estimates included. Treasury secretary Paulson said flat out that the plan will cost US taxpayers "hundreds of billions" of dollars. Some members of Congress put the price tag of the bailout at $1 trillion, and we've even seen some market economists' estimates in the order of a whopping $3 trillion. When you consider that a handful of the major US banks held roughly $500 billion of these troubled "level 3" assets as of 2Q, this suggests the total holdings across the entire financial landscape are colossal. Thus, the real cost of this measure could indeed surpass the $1 trillion mark. Congress will meet with Treasury and Fed officials over the weekend and we expect details to emerge shortly thereafter.

2) Ban on short-selling financial equities

In an attempt to stem the declines in shares of US financial companies, the Securities and Exchange Commission enacted a ban on short selling shares of roughly 800 companies. The ban in the US is set to run through October 2nd, while a longer-term measure in the UK (enacted a day earlier) bans short-selling of financials through the end of this year. This gives the financial sector some breathing room while the mortgage bailout is worked out, though it will be curious to see what happens once the US rules expire. The fact that many of these institutions will likely have to take write downs on their sale of toxic mortgage assets to the government could see their share prices come under pressure once again.

3) Backstop for money market funds

The losses in financial stocks seeped into the assets of many money market funds this week, leading to an exodus (~$90 billion) of cash as investors feared the worst. Fearing a classic "run on the banks," the US Treasury pledged to insure investor losses in such funds through the next year. The Treasury will seemingly use an "emergency pool" of roughly $50 billion to backstop the losses. This added safety net could see a major influx of cash into these funds, where the rates of return are typically higher than those of risk-free assets. If this flood were to also come from overseas, it would be an overall positive for the buck.

Key data and events to watch this week

The US data calendar is relatively light next week, but other, more import events will be closely watched. All eyes will be on Treasury secretary Paulson and Fed chairman Bernanke as they testify on the credit turmoil on Tuesday before a Senate panel. Bernanke is up again on Wednesday, testifying before the Congressional Joint Economic Committee. Thursday has Paulson and Bernanke together again, this time before a House panel where they will talk about the GSE takeovers. In data, the action kicks off on Wednesday with existing home sales. Thursday is busy with initial jobless claims, durable goods, and new home sales due up. Friday rounds out the week with the final cut on 2Q GDP and the University of Michigan confidence survey.

It is a touch busier in the euro zone in terms of data. French consumer spending kicks things off on Tuesday, with PMIs for the euro zone also due up that day. Wednesday sees French business confidence, euro zone current account and the German IFO business climate survey. Germany's all-important GfK consumer confidence survey is up on Thursday. Friday closes out the week with German import prices, French consumer confidence, and French final 2Q GDP. ECB speakers next week include Trichet on Monday, Stark on Wednesday, and Bini Smaghi on Thursday.

In the UK, it's all about housing in a very light week. Rightmove home prices are on deck for Sunday night, followed by home purchase loan data on Tuesday. On the speaking circuit, we have the BOE's Gieve on Monday, Sentance on Wednesday, and Barker on Thursday.

Japan also sees a very light week. The all industry activity is up on Sunday evening, and then we wait until Wednesday for the trade balance numbers. Thursday rounds out the week with consumer prices. BOJ board member Noda is scheduled to speak on Thursday as well.

Canada sees little action next week also, starting with retail sales on Monday. Tuesday sees consumer prices, and Thursday has Bank of Canada governor Carney on deck.

Last but not least, it is extremely quiet down under. New Zealand Westpac consumer confidence starts it all off on Wednesday. The RBA releases its Semi-Annual Financial Stability Review on Thursday, with New Zealand GDP also up that day. Friday rounds out the week with Australian new home sales.

By Brian Dolan of

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