The Rescue Package Passes, Finally; Will Hope Emerge?

10/06/2008 10:31 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

After an ugly balk on Monday, the US Congress has passed the Troubled Asset Relief Program (TARP). The main thrust of the legislation is to allow the US Treasury to buy illiquid mortgage-backed securities (MBS) from banks and other financial institutions, removing the problematic assets from their balance sheets. The hope is that the cloud of suspicion between financial institutions will then be lifted, allowing banks to raise new capital and resume lending to the broader economy. The sooner the flow of credit can be restored, the hope-thread continues, the milder the drag on the US economy is likely to be. As you can see, a lot of what is happening is aimed at shoring up confidence, both in the financial system and in investors' and consumers' minds. As commentators across the spectrum have been noting, this is not a silver bullet and it seems unlikely that markets will immediately rebound. It will take time for the Treasury to implement the program, time for the banks to raise capital, and time for investors' fears to fade. But a corner has been turned, and I look for a gradual easing of systemic pressures over the next several weeks. I hope.

The last few months have seen investors of all stripes move to the sidelines and take their cash with them. I look for this cash to be put back to work in relatively short order, given the steep declines in markets and abundance of bargain opportunities. I will be looking at key barometers of risk sentiment in various asset classes to gauge the recovery of risk appetites: in stocks, a lower VIX; in gold, lower prices; in Treasuries, higher short-end yields/lower prices; and in FX, a recovery higher in the JPY-crosses, or carry trades (e.g. USD/JPY, EUR/JPY, and GBP/JPY). The USD has strengthened sharply this week against most other major currencies, but I think it is likely overdone on a short-term basis. Weakness in EUR, GBP, and AUD has dragged down those currencies against the JPY, but with interest rate relief in store, the view may emerge that easier monetary policy will prevent a deeper economic downturn. In the current environment, monetary policy intransigence (i.e. not cutting rates) appears to be a currency negative. I'll need to see if interest rate relief down the road produces the opposite effect. The major risk to this outlook is that I am premature and there is a final spasm of market pessimism, resulting in a capitulation collapse across asset classes.

Over the next few weeks, I will be focusing on buying dips in the various JPY-crosses, in what is likely to be a choppy consolidation in the major USD-pairs. After all, with growth slowing across the G10 and elsewhere, excessive under/over performance by any particular currency should not persist for long. From the charts, I am struck by the many 'doji' patterns (where the open and close are virtually identical, leaving no or a very small real body) appearing on daily candlesticks. Doji are ultimately neutral and represent uncertainty and indecision with respect to the current directional move, but they are frequently a potential reversal signal. Next week's developments in credit markets (see below) will be critical to the near-term USD outlook. If conditions improve sufficiently, the USD may soon lose a major source of demand, triggering just such a reversal.

Credit Markets Hold the Key

Much of the USD strength this week was heavily influenced by the massive amount of US dollar demand on the back of the global credit market congestion. Now with the passage of the TARP plan, the hope is that the credit markets will once again begin to flow. This in turn should see the buck lower as functioning credit markets will reduce the demand for dollar liquidity. There are a couple of indicators that should give us a pretty good sign as to whether the congestion has eased. We would look for the reversal of these currently very tight credit measures to signal USD weakness ahead.

The Libor OIS spread—which measure the difference between the rate banks use to lend to each other and the Fed funds—rate recently blew out to a whopping 488 bps. Meanwhile, two-year SWAP spreads (also a measure of the cost of borrowing between counterparties) remain at a very wide 153 basis points. Under normal conditions, Libor OIS would be trading at a spread of about ten bps while SWAPS would be closer to 40 bps. We believe that as the TARP is implemented, via the Treasury's purchase of bad mortgages from banks, these spreads should begin to narrow. This would create a global environment of more fluid credit markets and in turn lower USD demand.

Major Central Bank Rate Decisions Next Week

The Reserve Bank of Australia is set to decide on rates on Tuesday and the consensus expects a -50 bps cut to 6.50%, though 1/4 of forecasters are looking for a more modest -25 bps cut. The slowdown in the global economy results in weakening demand for commodities worldwide and this is hurting the commodity-based Australian economy. Indeed commodity prices have plunged more than -10% in the latest week alone. Thus the risk of a -50 bps cut is very real especially if the RBA looks to nip the impact from lower commodities in the bud. RBA Governor Stevens noted recently that economic activity could "weaken more sharply than necessary" if rates are left high for too long. So a rate cut here looks to be baked in the cake. Given that the market expects the more aggressive -50 bps cut, we would expect good buying of AUD if the bank goes with the modest -25 bps instead.

The Bank of England is also meeting on rates next week (Thursday) and consensus is for a -25 bps cut to 4.75%. The outlook here is more contentious with 1/4 forecasting no change and a small minority looking for a more forceful -50 bps. The fact that consumer confidence, business activity, and other measures of economic output have continued to deteriorate leaves the door open for the more aggressive -50 bps cut. That said this is less likely given that the bank needs to stay true to their mandate of fighting inflation. Consumer prices are running at a whopping 4.7%, which is the highest run-rate since the early 1990s. The outcome for GBP looks to be negative either way as the move in rates will elicit a statement from the BOE, which is likely to be quite negative on the economic outlook. Thus it will come down to a matter of degree, where a -50bps cut should see the pound crushed with a risk that GBP/USD tests the 1.70 mark.

The Bank of Japan is also on tap next week and the market is unanimous in predicting that rates will remain unchanged at 0.50%. If past is prescient, this will turn out to be a non-event. Fed Chairman Bernanke is expected to set the tone for Fed rate cuts when he speaks next week. However, we believe he is unlikely to mention rate cuts until the recently passed TARP plan is given a chance to work its way through the credit markets. With Fed funds already at a very low 2%, the Fed will likely shy away from cutting further as this will risk stoking inflation. Besides, the fundamental problem in credit markets is not the "cost" of funds but the availability of them. Counterparty risk is through the roof as lenders remain fearful that borrowing institutions could be wiped out overnight. The bailout is meant to clean up the balance sheets of these risky institutions and thus help open up the credit spigot. Bernanke is unlikely to adjust rates until the plan is given a chance. Thus the current 100% odds that the Fed will cut -50bps in October look to be premature at this point.

Key Data and Events to Watch Next Week

The US calendar is light on data and heavy on speakers next week. Data starts with consumer credit on Tuesday and pending home sales on Wednesday. Thursday sees the usual initial jobless claims and wholesale inventories while Friday closes out the week with international trade and import prices. The speaking agenda is jam-packed with Evans, Fisher, Stern, and Bernanke due up on Monday. Plosser speaks on Wednesday while Stern and Rosengren are due up on Thursday. Also look for the FOMC meeting minutes due to be released on Monday.

The Euro-zone calendar is a little lighter and kicks off with investor confidence on Monday. Tuesday has German factory orders on deck and Wednesday sees German industrial production along with the final cut on Euro-zone 2Q GDP. German wholesale prices and trade balance are up on Thursday while French industrial production rounds out the week on Friday. In terms of speakers, Juncker is due up on Tuesday while Trichet is scheduled for Tuesday and Thursday. The usual monthly European Finance Ministers meeting is on Monday next week as well.

It is ultra-light in the UK with the BOE rate decision the main highlight (see write-up above). The NIESR GDP estimate is due up Monday followed by industrial production and consumer confidence on Tuesday. The trade balance rounds out the week on Thursday.

Japan's calendar is on the light side as well with the BOJ monetary policy meeting kicking off the action on Monday. The leading index is due on Tuesday and machine orders close out the week on Wednesday.

Canada sees an uncharacteristically busy economic calendar. Monday start it off with building permits and the all-important Ivey PMI while housing starts are on tap Wednesday. Friday is very busy with the employment report, international trade, and new home prices. Look for the Bank of Canada Senior Loan Officer Survey on Friday as well.

It's pretty light down under and the RBA rate decision highlights the week (see our more in depth analysis above). New Zealand business confidence kicks the data off on Monday and Australian consumer confidence is up on Tuesday. Wednesday has Australian home loan data while the Australian employment report and consumer inflation expectations round out the week on Thursday.

By Brian Dolan of

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