The story is the same as we have seen over the past few months. Institutional investors and hedge funds are having to pay down some of the loans which they have taken out over the past few years. These investors had been rolling over loans in the lower yielding currencies of the yen, franc, and dollar in order to pick up the ‘carry’ between these low interest loans and their higher yielding investments. Now, due to the credit crunch, the banks are not renewing these loans, and the institutional investors have to sell investments and buy back the yen, franc, and dollar in order to pay off the banks. In addition to the flow of funds to pay off these bank loans, investors are also having to purchase dollars to make up for the losses which they are incurring on US$ based mortgage investments and credit default swaps.

A question we hear a lot these days is when will this stop? That question is very difficult to answer, as hedge funds are mostly unregulated so there is no good data on just how much leverage there is. Making it even more difficult, the credit default swaps do not trade on an ‘exchange’ so it is almost impossible to try and gauge just how much of these swaps are outstanding. For those of you who are new to the Pfennig, credit default swaps are agreements which were entered into by institutions which guaranteed holders of certain mortgage backed investments against the risk of default. They are basically insurance policies on mortgage backed investments. These swaps are contracts between two parties, and are not cleared on a common exchange. As mortgage backed securities have plummeted, holders of the credit default swaps have started collecting. The vast majority of these derivative contracts are issued in US$, so when holders collect, the issuers have to pay off in US$, and sometimes have to sell investments in other currencies to raise the US$.

But I digress, back to just how long this will last. No one knows. As long as the losses keep mounting on Wall Street, and volatility continues, investors will continue to have to buy dollars. I know this isn’t helpful to readers who want someone to tell them right when the bottom is, but anyone who tells you they can predict these markets is delusional. I can only tell you that at some point the deleveraging will be complete, and the markets will start trading back on fundamentals. The fundamentals are not good for the US$, as we continue to increase debt and widen our deficits.

As I informed all of you yesterday, Alan Greenspan was on Capitol Hill yesterday urging Congress to increase regulation of the financial system. Greenspan admitted the credit crisis had exceeded anything he had imagined and he was wrong to think that banks would protect themselves from financial market chaos. “I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders,” he said. Big Al accepted that the crisis had ‘found a flaw’ in his thinking but said if we had regulated enough to prevent the crisis, growth in the US would have been slower. Greenspan’s ‘growth at all costs’ attitude led his Fed to ignore the possibility that greed could cause Wall Street to misprice securities.

But Big Al still didn’t take all of the blame. Deflecting criticism, Mr. Greenspan said that when, as Fed chairman, he declined to advocate regulating credit default swaps – derivatives which have been blamed for worsening the crisis – he had been following the will of congress.

As I mentioned above, the Japanese yen climbed to a 13 year high against the dollar overnight. The de-leveraging and risk aversion continues to prompt the strengthening of the yen. The Japanese currency also surged against the euro after Belarus, Ukraine, Hungary and Iceland joined Pakistan in requesting at least $20 billion of emergency loans from the IMF. Fear that pressures in Eastern Europe will have a negative effect on Euroland is another reason the euro continues to drift lower vs. the US$. European banks lending to emerging markets is about 21 percent of GDP and UK banks loans are around 24%, compared to 4% for the US and 5% for Japan. Eastern European currencies continue to be under speculative attack, and the currency markets are selling the Euro due to its close relationships to these emerging markets.

The IMF bailout of Iceland has been delayed over the fate of the money from UK savers that is frozen in an Icelandic bank. The IMF is apparently insisting that Reykjavik’s dispute with London over British savings held in Icesave, the UK offshoot of Iceland’s Landsbanki, is resolved before it will make a decision on the scale of emergency support. The IMF’s board met last night to debate the potential rescue package for Iceland, which could total $6 billion. It would make Iceland the first Western country to receive an IMF loan since Britain went to the fund in 1976. Since the meltdown of the Icelandic banking system earlier this month, the bulk of money held in Icelandic banks has been frozen. We have been unable to sell the Icelandic CDs which matured this week, and are awaiting further news from our currency dealers.

The Danish central bank bucked the trend and unexpectedly raised rates by 50 bps to an eight year high, showing policy makers will defend the krone even as the economy teeters on the bring of recession. India’s central bank also surprised the market by leaving their interest rates unchanged and signaled it may hold borrowing costs in the coming weeks to balance inflation and growth concerns.

Another central bank which continues to try and protect their currency is Brazil who plans to offer as much as $50 billion in currency swaps to prop up the real. President Luiz Inacio Lula da Silva said his government will take all necessary steps needed to reduce the effect of the global credit crunch on Latin America’s biggest economy. The efforts have thus far been in vain, as the Brazilian real has sold off over 11% in the past 5 days.

A continued fall in commodity prices negatively impacted the commodity currencies of Australia, Canada, and New Zealand. Canada’s currency fell on speculation the global economic slump will deepen and crude oil prices will fall further. Canada’s annual inflation rate remained close to the highest in five years in September as gasoline prices kept surging and food prices rose. But the Bank of Canada, which has lowered interest rates by three-quarters of a point this month, said yesterday that inflation in the country has probably peaked.

Gold fell overnight, trading down to $682 per ounce. The fall is blamed on fund liquidation and the US$ rise. Gold is usually seen as an investment safe haven, but its recent slump has defied conventional wisdom. But with the equity market’s dramatic falls, investors have been selling the hard asset in order to meet margin calls. Sales have also been generated due to the global deleveraging, as investors have to raise US$ to pay down loans.

Currencies today 10/24/08: A$ .6169, kiwi .5540, C$ .7888, euro 1.2638, sterling 1.5614, Swiss .8677, ISK (No Quote), rand 11.037, krone 6.843, SEK 7.8513, forint 218.18, zloty 3.038, koruna 19.81, yen 92.66, baht 34.70, sing 1.5055, HKD 7.7507, INR 49.989, China 6.8438, pesos 13.63, BRL 2.366, dollar index 86.09, Oil $63.17, Silver $8.93, and Gold… $702.90

That’s it for today…Another very busy day on the trading desk yesterday, and with the volatility overnight I expect today will be the same. While I enjoy Pfilling in for Chuck on the Pfennig, I have to admit I am bit excited about letting him take back the helm on Monday. These volatile markets are tough on newsletter writers! Looking forward to a big sports weekend, as I am going to the Blues game tonight and then off to Columbia for MIZZOU’s homecoming tomorrow. I will head back home on Sunday to go play paintball with my 13 year old son’s hockey team. Sounds like a great fall weekend!! Hope everyone has a Fabulous Friday and Wonderful Weekend.

Chris Gaffney
October 24, 2008

Global Deleveraging Continues originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Chuck is headed back home this afternoon, after spending the past two weeks traveling the country with FX University. I’m sure he will be happy to get to sleep in his own bed again tonight, and will catch up on his rest tomorrow. He sent me the following note to share with readers:

“Well… Another day and another dollar rally… I’d like to thank Chris for all his work on the Pfennig while I’ve been out. I’ll talk to you all on Monday. But for now… Chris did an excellent job putting together all my different reasons for the dollar being so strong yesterday, didn’t he? Since nothing’s changed in that regard, and nothing probably will for months, I thought I would skip the dollar talk and go somewhere else…

“First of all… Here’s a quote by Thomas Jefferson that really struck a chord with me… (And remember… Thomas Jefferson wrote this over 200 years ago!)

“‘The central bank is an institution of the most deadly hostility existing against the Principles and form of our Constitution… Bankers are more dangerous than standing armies… (and) if the American people allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and CORPORATIONS that will grow up around them will deprive the People of all their property until their children will wake up homeless on the continent their Fathers conquered.’

“Now if that doesn’t shake you up, and get you mad at all these dolts who have put our country in this mess (and that’s now spreading into Europe), I don’t know what will… OH! Maybe it’s this…

“Yesterday, I came across a story regarding the audit of the credit ratings agency, Moody’s… You see, the examiners are convinced that ratings Agencies employees were doing no good in rating those mortgage bonds so high. Well, in an examination of various emails, they found this quote by an employee of S&P (according to the story on Bloomberg), ‘Let’s hope we are all wealthy and retired by the time this house of cards falters.’

“And also from Bloomberg… ‘And in an investigation over at Moody’s…the employees at Moody’s Investors Service told executives that issuing dubious creditworthy ratings to mortgage-backed securities made it appear they were incompetent or “sold our soul to the devil for revenue”‘.

“Shame, shame, shame… Shame on all of you! But then, they haven’t been convicted of anything yet, so in this country they are presumed innocent until found guilty…”

Chuck always calls it like it is! And he just sent me another message reminding me that the founding father of all of this mess, Alan Greenspan, will be on Capitol Hill today addressing the House Committee on Oversight and Government Reform. Big Al was very vocal in his aversion to increasing financial supervision as Fed chairman from August 1987 to January 2006. He said in a May 2005 speech that “private regulation generally has proved far better at constraining excessive risk-taking than has government regulation.” During his term at the Fed’s helm, Greenspan repeatedly warned lawmakers against inhibiting markets, such as by tightening oversight of certain types of derivatives.

Greenspan’s office released a copy of the prepared testimony he will give to congress today, and in it, the Former Fed head does a dramatic about face. He is now trying his best to distance himself from the free-market culture that he helped create. But during his testimony today, he will call for tighter regulation of financial companies. “Firms that bundle loans into securities for sale should be required to keep part of those securities,” Greenspan will say in his testimony today. Other rules should address fraud and settlement of trades, he will say. I doubt if any of his buddies on Capitol Hill will really let him have it (they let the rating agency heads skate right on through yesterday). As usual, the individuals who were asleep at the wheel during the creation of this crisis will be let off the hook and left to enjoy their retirement while all of us taxpayers pay for their excesses.

I haven’t written much about the data releases in the U.S. this week, as it has been a very slow data week. Today will be the most interesting piece of data as we will get the weekly jobs numbers along with the U.S. house price index. Initial jobless claims will probably increase again this week, as the U.S. economy continues to stumble along in a recession.

Yesterday we got more bad news on the U.S. housing front, as U.S. foreclosure filings increased 71% in the third quarter from a year earlier. Foreclosures are now at the highest on record, as home prices continue to fall and stricter mortgage standards make it harder for homeowners to sell or refinance. As we have repeatedly warned, the government bailout on Wall Street will not have an impact on the housing market slide. All of the money given to the big Wall Street financial firms is being used to make up for the losses they have on the ‘creative’ investments they sold each other. All of the talk about how this bailout money will help homeowners is just a bunch of Paulson doublespeak.

Now the administration is finally starting to talk about giving homeowners some relief, with both the candidates and congress suggesting we come up with a second bailout package aimed at individuals. I guess the first $1.3 trillion just didn’t do the job, or maybe it was just aimed at the wrong institutions. As we have been saying all along, this financial crisis still has a few surprises to spring on us, and it is far from over for the U.S. taxpayers.

One of the reasons I have heard for the fall of the euro (EUR) is that currency traders expect the ECB to continue to cut rates to stimulate their economy. But ECB President Trichet has held to his commitment to combat inflation, which continues to hold above the ECBs 2% target. But on this side of the Atlantic, officials are more than willing to ignore inflation, as our FOMC is expected to continue to be very aggressive cutting rates over the next few weeks. The FOMC will probably reduce the benchmark federal funds rate by half a point next week to just 1%, the lowest since May of 2004. The official rate has never been lower. So how can currency traders be taking the euro lower on the mere possibility of ECB cuts when the United States has all but guaranteed even more aggressive reductions? It doesn’t make sense to me, but none of the markets haven’t been making much sense lately!

Both the Reserve Bank of New Zealand and the Riksbank in Sweden cut rates last night. New Zealand cut by a record 100 basis points last night in an aggressive move to stimulate their economy. The RBNZ did not express concern over the fall of the New Zealand dollar (NZD) or imported inflation in their accompanying statement. The kiwi initially rallied on the cut, as markets had actually priced in an even more aggressive cut. But the short rally didn’t last and the kiwi is opening up this morning down slightly from where it was trading yesterday.

Sweden cut its key lending rate by a half-point for the second time in two weeks and forecast another similar reduction within six months to cushion the economic slowdown. It also lowered forecasts for growth and inflation. “The interest rate cuts are aimed at alleviating the effects of the financial crisis on the real economy and at the same time attaining the inflation target of 2 percent.” The cut was widely expected so it didn’t have a dramatic impact on the Swedish krona (SEK) which is actually up a bit versus the U.S. dollar.

The yen continued to strengthen overnight, but was joined by some strange bedfellows. We are used to seeing the yen rally as currency trades are reversed, but over this morning the high yielding currencies of South Africa (ZAR), Mexico (MXN), and Brazil (BRL) have joined it. As I mentioned yesterday, expect the unexpected in these markets. Apparently the South African rand is rallying after the central bank assured investors that banks in South Africa are well-capitalized and won’t need a government bailout. South African banks have very little direct holdings in U.S. subprime related assets and do banking in a more traditional manner. The report from the central bank assured investors that the banking system in South Africa is very well regulated and ’safe and boring’.

The rand rallied in spite of another drop in gold, which is close to breaking below $700 per ounce. And I thought my purchase at $850 was well-timed! We continue to have trouble buying coins or bars in either gold or silver, so the shortage of the physical metal remains. Apparently much of the selling of gold and silver is coming from institutional holders who are having to raise cash, and are using sales of these hard assets. I continue to believe that both gold and silver are cheap at these levels, as global inflation will spike as a result of the tremendous increases in global money supplies.

On to the currencies:

Currencies today 10/23/08: A$ .6603, kiwi .5879, C$ .7873, euro 1.2795, sterling 1.6185, Swiss .8570, ISK (No Quote), rand 11.18, krone 7.1741, SEK 7.8481, forint 222.26, zloty 3.0928, koruna 20.2269, yen 97.35, baht 34.63, sing 1.5029, HKD 7.7529, INR 49.82, China 6.8355, pesos 14.1105, BRL 2.5052, dollar index 85.67, Oil $68.10, Silver $9.3663, and Gold… $706.37

That’s it for today… I will be happy to see Chuck back in the office next week, hopefully he will bring a little currency rally along with him. Blues lost a tough one last night, but are still off to a great start. My wife and I will be heading to the hockey game on Friday night, and Chuck will be going also. I just heard that Sarah Palin will be dropping the puck, so it should be a fun night. The markets continue to be crazy, and the phone volume has picked up again, so I’ll have to jump now. Hope everyone has a Tub-Thumpin Thursday!!

Chris Gaffney
October 23, 2008

Greenspan Goes to the Hill originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Here is as good an explanation as I can give: Over the past several years, money was extremely cheap, and investors took advantage of these cheap loans. Hedge funds, corporate investors, and even some individuals borrowed funds and placed them into higher yielding investments to earn the ‘carry’. This occurred not only in the currency markets, but across the entire spectrum of asset classes. These investors were rewarded with incremental yields over ‘cash’ investors, and banks were more than willing to lend, so the amount of leverage continued to increase to absolutely absurd levels. Everything was fine until the housing market here in the United States turned, and losses started to show up on the books of some investors.

These investors had to sell some of their higher yielding assets to make up for the losses, and a move toward deleveraging started to emerge. As these first investors sold these assets, their price dropped, forcing still others to sell. The credit crisis, and the lockup of the credit markets was a final straw in the leveraged carry trades. Even investors who wanted to stay in the trades could no longer get the loans to keep these trades alive. They were forced to deleverage, selling their investments to pay back the loans.

So the benefactors of this deleveraging of the financial system? The Japanese yen (JPY) and the U.S. dollar, currencies which were used to funds these carry trades. The United States and Japan have some of the world’s largest banks, and extremely low interest rates, making them the perfect funding currencies for the carry trades. As the deleveraging has occurred, investors have purchased back these currencies to pay back loans. Also, a majority of the investors participating in these trades were based in the United States, so the deleveraging meant a move back to the U.S. dollar. U.S. investors purchased nearly $1 trillion in foreign stocks and bonds since 2003, many of which are now being sold with the proceeds moving back to the U.S. dollar.

The dollar has also benefited from other factors, including the printing presses at the Treasury – which have been running overtime. Bernanke and Paulson have increased the money supply at an incredible pace. Some of these dollars the U.S. Treasury Department is creating are being used by foreign central banks in ’swaps’. These swap contracts allow the foreign central banks to swap their local currency (a majority are in euros (EUR)) into U.S. dollars to lend to their institutions who are offsetting losses in their dollar-based investments. And even investors who don’t have the ability to enter into ’swaps’ with the U.S. Fed, still have a need to offset losses that have piled up on mortgages and other dollar-based investments. The choice for these investors is to sell these assets, which have dropped to fire sale levels, or borrow their home currencies (in this case euros) to buy dollars (this would be a reverse carry trade).

So the deleveraging of the global financial system, at least to me, certainly seems to be one of the primary factors propping up the U.S. dollar. But where will it end? These are some extraordinary times, and the markets are anything but normal. Anyone who thinks they can tell individuals what is going to happen in the markets over the short-term are on something. Ty Keough said it best in responding to a caller’s request to have him try and predict what was going to occur in the markets over the next few weeks. Ty told the caller, “The only prediction I will make is that the next thing to happen will be something we have never seen before. Expect the unexpected!” But over time, markets will settle back to the underlying fundamentals, and the current fundamentals don’t support a stronger dollar.

Chuck is spending the rest of the week at the EverBank headquarters down in Jacksonville. He sent me these thoughts to share with readers this morning:

“Here I am in Jacksonville after having a wonderful dinner with some of the great folks here. I came back to my room and checked the currencies to see that the euro had lost another 2 cents to the dollar. UGH! As I said a couple of weeks ago, I’ve risen the white flag. This is just crazy, all this dollar strength… But it is what it is, and again, I’m going to stick to my fundamentals, as they have never let me down before…

“I’ve told the crowds that this reminds me of 2005 so much… The dollar gained, and gained all the way to 1.18/euro, and the dollar bulls were dancing in the streets, saying that the dollar’s bear market had come to an end, only to find out the dollar had been propped up by the Tax Amnesty for U.S. Corporations doing business overseas. Once that Tax Amnesty ended, the fundamentals for the dollar returned to push the dollar down over the next two and a half years.

“Now, we have this financial sector meltdown pushing the dollar up once again. The worldwide demand for dollar funding is driving the dollar higher every day. It’s amazing to see that everyone wants dollars to fund their capital requirements, etc. I’m feeling very overwhelmed, to say the least, regarding this dollar strength… But, it is what it is…

“Speaking of being what it is… Let’s talk money supply… I had a go with someone the other day regarding the current money supply being put into banks. He said that this money supply was not going to cause inflation… But I said, ‘the true definition of inflation is money supply increasing.’ He said that this money supply was not going to the banks to stimulate the economy; it was going shore up the bank’s books… So I said, ‘well, it’s still money supply, and you can’t tell me that this isn’t going to eventually enter into the economy and stimulate inflation.’ Then I went on to say, ‘Banks can’t stay in business, or survive without making loans, so they may need to shore up their books now, but eventually, they are going to have to put that money to use!’ But for now… I have to take my lumps…”

Yes, the dollar strength is pretty overwhelming for all of us here on the trade desk.

The pound sterling (GBP) slid to the lowest level in more than five years against the dollar after BOE Governor, Mervyn King, said that Britain’s worst banking crisis since World War I is likely to push the economy into a recession. King’s comments came after the Bank of England released minutes from their October 8th meeting, when they voted unanimously to lower their benchmark rates 50 bps. Yesterday’s decline of the pound was the steepest intraday decline in 16 years. And the short-term outlook continues to be bearish, as weekly and monthly stochastic and trend indicators show a target for the pound of $1.60.

The Bank of Canada reduced its main interest rate by a quarter of a point – less than economists predicted. But central bank Governor, Mark Carney, said that they would probably need to act again to fend off the effects of the global recession. The Canadian dollar (CAD) joined most of the other currencies and slid versus the U.S. dollar yesterday after the rate announcement. Canadian exporters will be hobbled by a U.S. recession, and the free fall in commodity prices. But policy makers stopped short of saying that Canada’s economy is headed for a recession. This month, the World Economic Forum rated Canadian banks as the soundest in the world – but these banks are still reluctant to lend. A further cut in rates, and falling commodity prices will keep the loonie under pressure.

Emerging market currencies were the biggest losers overnight, as Argentina’s planned seizure of private pension funds stoked concerns that the nation faces its second default this decade. South Africa’s rand (ZAR) fell to a 6.5-year low against the dollar, joining the Brazilian real (BRL) and Mexican peso (MXN) as the worst performing currencies. The rand moved above 11 rand per dollar for the first time since April 2002, as the move away from emerging markets combined with another fall in the price of gold to put downward pressure on the currency. South Africa’s economy is similar to that of the United States in that they rely heavily on portfolio inflows to fund their current account deficits. These portfolio inflows aren’t going to be forthcoming in the current environment of risk aversion.

Brazil’s currency continued to fall despite government efforts to shore it up. Brazil has spent $22.9 billion in the past month in an attempt to slow the fall of the real. Sales of reserves to buy reals in the spot market totaled $3.2 billion from October 8th through October 20th, central bank President Henrique Meirelles said in testimony before congress late yesterday. But Brazil is not alone in trying to prop up their currency. Mexico, which has a smaller economy, spent even more on currency intervention during the same period. Mexico’s central bank bought $6.4 billion worth of pesos on October 10th alone to shore up the currency.

Brazil is getting somewhat of a bum rap by the currency markets, as their economy is doing fairly well amid the global credit crisis. The government’s debt as a percentage of gross domestic product fell because the country is a net dollar creditor. Capital levels at Brazilian banks exceed the minimum amount required under international guidelines. And while Brazil is known for commodity exports, only 13% of their GDP comes from exports. They depend more on domestic demand than foreign markets, so they should be somewhat protected from a reduction in global trade.

In other emerging market news, Hungary’s central bank raised interest rates 300 bps today after a series of earlier measures to prop up the forint failed to halt the flight of investors. The first emergency increase in five years came after policy makers left rates unchanged at their scheduled meeting two days ago. Investors should continue to monitor the situation here, as Hungary continues its attempts to avoid further falls in their currency.

To end on a positive note, the Japanese yen has benefited from all of the deleveraging, and traded back down below 100 overnight. The yen continues to be the only bright spot in the currency markets over the past 3 months, as it has gained 8.2% versus the U.S. dollar.

Currencies today 10/22/08: A$ .6713, kiwi .5951, C$ .8044, euro 1.2842, sterling 1.6324, Swiss .8579, ISK (No Quote), rand 11.017, krone 7.0117, SEK 7.881, forint 214.73, zloty 2.9390, koruna 19.876, yen 98.51, baht 34.54, sing 1.4985, HKD 7.7527, INR 49.34, China 6.8342, pesos 13.7438, BRL 2.3465, dollar index 85.49, Oil $69.31, Silver $9.7699, and Gold… $753.63

That’s it for today… I wanted to wish my father a happy birthday today. He has been suffering from Parkinson’s diseases for several years, and my mother had to make the difficult decision to move him into a home last year. But he is receiving tremendous care in his new home, and we they are hosting a big birthday dinner for him tonight. Hope everyone has a Wonderful Wednesday! Happy Birthday DAD!!

P.S. To get The Daily Reckoning sent directly to your inbox, sign up for our free email newsletter, or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Chris Gaffney
October 22, 2008

Deleveraging Pushes Up the U.S. Dollar originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.