Back to the Days of Volcker

Good day… The dollar drifted lower yesterday as the markets digested the latest bailout by the Fed and tried to predict just how big a rate cut we would get today. Risk has definitely returned to the markets, and the near collapse of Bear Stearns has got everyone wondering who will be next. With investors shunning risk, the remaining carry trades continue to be reversed with dramatic effects on the high yielding currencies of Iceland (ISK) and South Africa (ZAR). But first I will review the data that we got yesterday and the numbers due to be released today.

The markets largely ignored the data released yesterday as they were more concerned with the emergency action taken by the Fed. But the numbers do deserve a look, as they pretty much confirm just how bad our economy is doing, and the very fragile state we are in. The Current Account Balance for the fourth quarter showed a deficit of just under $173 billion after a revised $177 billion in the third quarter. In an accompanying statement, the Total Net Tick flows showed that foreigners increased their holdings of U.S. Treasuries by just $37.4 billion, down from $72.7 billion in December, and $135 billion in November. This is a scary trend, as we have come to rely on these foreign investors to finance the current account deficits I reported on earlier.

Other data released yesterday showed that industrial production dropped 0.5% during February and the empire manufacturing number dropped dramatically to -22.2. Manufacturing is in a tailspin following the lead of the construction industry. Some have said the dramatic fall of the U.S. dollar will have a positive impact on our economy as it will help our manufacturers with their exports. The problem is, we don’t really make anything anymore! Don’t look for a weak dollar to pull us out of our current situation.

Today we will get more bad news, as housing starts and building permits are expected to show that home construction has dropped to a 17-year low. We will also see if inflation is still heating up with the release of February’s Producer Price index. Readers know just how much credibility we give the inflation reports coming out of our government, but it will still be interesting to see just how much inflation they want to show us on a day that the FOMC is expected to cut 100 basis points.

That’s right, the markets are now pricing in a dramatic 100 basis point cut by the FOMC at today’s meeting. The official estimate remains at 75 bps, but just about every story I read is predicting a full percent move. This would be the deepest rate cut in a generation. Paul Volcker was in charge of the Fed the last time we got such a big move back in 1984 and that was from a base of 11.75%. This cut would bring the benchmark interest rate down to just 2%, and doesn’t leave much room for further cuts.

This is the problem with such a big move; the FOMC is using up all of their ammunition in their fight with the credit markets. They have been aggressively throwing money at the banks and credit markets, but to no avail. Credit is still very tight with everyone afraid to lend to the ‘next Bear Stearns’. I’m afraid at some point the Fed may just have to throw in the towel like Duran in his famous fight with Sugar Ray Leonard crying No Mas, No Mas!!

I read an amusing article which compared the Fed’s recent actions to the Whack-A-Mole game. As each credit crisis has popped up, Ben Bernanke has whacked it back down with a fist full of dollars. But the big concern is that – just like in the game – credit problems are now popping up at a quicker pace, and the Fed is quickly running out of cash to whack them back down.

The Fed has already given up on the dollar. The recent moves show they really don’t care how quickly the greenback is sinking as they are much more concerned with trying to get a handle on the credit crisis. I’m not suggesting that they should be concentrating on trying to keep the dollar strong, but I do believe that they should at least consider the inflationary impacts of their recent actions. They have thrown out any concern about the next few years, quarters, or even months, as they have focused on what will make the markets happy tomorrow.

Currency investors are joining equity investors as they have started another shift away from riskier assets. This means another reversal of the carry trade, which has benefited both the Japanese yen (JPY) and Swiss franc (CHF). But as we have reported in the past, there are both winners and losers in the carry trade, and the big moves by the yen and franc have been offset by big losses in the Icelandic krona and South African rand.

The Icelandic krona is down almost 10.5% in the past five days, by far the worst performer versus the U.S. dollar. The krona has been a favorite of investors who have leveraged up in order to take advantage of the highest interest rates available in the developed world. These highly leveraged investors have been hurt by the recent credit crisis, and have had to reverse these large positions. These sales have had a dramatic impact on Iceland’s currency, as there just aren’t enough banks and traders willing to buy the currency back. This is a risk that we have pointed out to investors with regard to this currency; it has a very small ‘float’. This causes wild swings in the currency as liquidity in the markets dries up, and it becomes tough to find buyers for the currency. I guess the only good news is that the Icelandic krona has been through this type of volatility in the past, and eventually the markets calm down and order is restored.

China tried to reign in inflation and speculators in the currency by taking a page out of a Thai playbook. China increased reserve requirements for the second time this year. Lenders must now place a record 15.5% of deposits with the central bank up from 15% previously. This move was directly aimed at speculators who have flooded the Chinese banks with money, adding even more fuel to the inflation fire. By increasing the amount of deposits held at the central bank, the Chinese central bank has taken more money out of the banking system. This has a similar effect as raising interest rates, and should serve to help slow inflation.

But an added effect is another increase in the cost of holding the Chinese renminbi (CNY) for investment purposes. The combination of the recent increase in market volatility and these higher reserve requirements have made it very difficult for investors to benefit from speculating on future moves in the currency. And this certainly won’t be the last move by the Chinese government, as they have said they will continue to take ‘appropriate and forceful’ actions to tackle soaring prices.

Currencies today: A$ .9275, kiwi .8072, C$ 1.005, euro 1.582, sterling 2.016, Swiss 1.0157, ISK 76.40, rand 8.085, krone 5.1086, SEK 5.9813, forint 163.39, zloty 2.2357, koruna 15.9180, yen 97.37, baht 31.21, sing 1.3767, HKD 7.7702, INR 40.51, China 7.08, pesos 10.7603, BRL 1.7220, dollar index 71.118, Oil $107.09, Silver $20.35, and Gold… $1008.20

That’s it for today… It was definitely a wild day on the trade desk yesterday, as we tried to deal with a record volume of calls. Today looks like it will be more of the same as investors rush to get out of the plummeting dollar. Chuck gets back tonight, so some relief is right around the corner. Thanks to everyone for the nice notes regarding my father, I appreciate them. Now let’s get on to the trading day, as the big boss says, “Onward and upward!!!” Have a Terrific Tuesday!

Chris Gaffney
March 18, 2008