Global Deleveraging Continues

St Louis, Missouri- Good day…The yen shot up overnight as the global deleveraging continued. Investors sold higher yielding assets to pay back debts in the Japanese yen, Swiss franc, and US dollar. The yen move all the way to a 90 handle before giving back some of its gains in early European trading. The Swiss franc was the only other currency which appreciated vs. the US$. The biggest losers overnight were the Australian and New Zealand dollars which both dropped over 7% vs. the US$.

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