A Band-Aid for the Subprime Mess

Good day… Chuck is off to Florida for another presentation, but as usual he left me with a few thoughts on what happened yesterday in the markets. You will find his thoughts throughout today’s Pfennig, and to try and keep it flowing, I will just put Chuck’s contributions in quotations. So here goes:

“Today is Pearl Harbor Day, the first day of infamy… I will take a moment of silence…

“OK… I’m back! Well… The White House introduced the plan yesterday to mitigate delinquencies and foreclosures. So far, I’ve seen as many critics of the plan as I’ve seen people lauding it. You know where I stand on this… And that is… I don’t like government sticking its hands in the private sector’s business. And in the end, will this plan stop house prices from falling? I don’t think so.

“S&P (Standard & Poor’s) said that they will have to issue downgrades of bonds due to this plan being passed… Hmmm… I didn’t like it when I first heard about it, and I like it even less now!”

After reading more about the government’s ‘rescue’ plan, I liken it to the commercial I have seen on TV lately where the inspector fixes a hole in a massive dam with some chewing gum. This Band-Aid may work for a small portion of the subprime borrowers, but won’t even come close to stopping the hemorrhaging that is going on in the housing market. It is nothing more than a political attempt at easing the U.S. consumers concerns regarding the economy.

While we will have to wait and see if U.S. consumers buy into the plan, investors seemed to like the plan. It gave all of the carry trade investors another opportunity to put their spread trades back on. As all of you know by now, when the carry trades get put back on, the yen (JPY) and Swiss franc (CHF) get sold and the high yielders see some relief.

The Brazilian real (BRL) rose the most in a week as the U.S. plan eased concern over tightening credit markets and renewed demand for emerging market assets. These investors obviously believe the U.S. government will continue to ride to the rescue and bail them out if/when they make a bad investment. This is exactly what got Chuck all lathered up earlier in the week when the plan was first announced. It is not that we don’t feel sorry for the poor homeowners who signed up for loans that they didn’t understand; but when investors see the government rescuing these individuals, risk becomes less of a concern. Lower risk premiums mean carry trades get put right back on. Now we just wait for the next bad data to be released and watch all of these carry trade investors head for the doors again. This carry trade roller coaster ride doesn’t look like it is going to end any time soon.

The Brazilian real also benefited from yesterday’s decision by their central bank to keep rates unchanged for a second consecutive meeting. The Brazilian central bank is concerned that inflation may accelerate and removed the word ‘pause’ from its statement and added a mention to the ‘prospective scenario for inflation,’ both of which contributed to a more hawkish view. I don’t expect the Brazilian central bankers to cut rates again until the end of next year, so the rate advantage that the Brazilian real enjoys over the U.S. will likely increase. High rates should keep the real well bid over the next several months.

Another high yielder that increased yesterday was the South African rand (ZAR) which also benefited from an interest rate increase. South Africa’s central bank raised its benchmark rate by half a percentage point, the fourth increase this year, as it forecast that inflation will stay outside of the target range until the second half of 2008. It is good to see some central banks still know their mandate is inflation targeting.

Norway’s krone (NOK) also advanced for a fifth day, touching its highest in more than a week versus the euro (EUR) on speculation interest rates will be raised. The krone had its longest winning run in a month as traders judge the fastest growth since at least 1979 will persuade the central bank to raise rates by a quarter of a point on December 12. Six rate increases from Norges Bank this year have failed to damp growth in Norway as recent record-high oil prices spurred investment and all-time low unemployment boosts consumer spending. Economic growth in Norway accelerated to 6.6% in the third quarter, the fastest pace for at least 30 years.

Now I will get back to Chuck’s comments on the markets:

“The European Central Bank (ECB) left rates unchanged yesterday as I expected them to… And ECB President Trichet sounded very hawkish after the meeting at his press conference. The markets acted as if Trichet had broadsided them… But in reality, he’s just being steady at the wheel, letting everyone know that the ECB are clearly worried about inflation, and putting market risks to the side, for now.

“The Bank of England (BOE) surprised me, not the markets, and pulled the dust covers off their rate cut machine… It seems they’ve torn a page out of the Fed’s handbook on how to kneel down to the markets and invite high inflation into their economy. But, I don’t live there, so I don’t know how bad it is, economy wise.

“The good news for U.K. exporters is that the pound sterling (GBP) lost quite a bit of ground this week, not only to the dollar but more importantly to the euro. I know, I bet you’re scratching your head right now wondering what I mean by that last statement… Ahhh grasshopper… It really is simple… A majority of the U.K.’s exports go to the European Union… So, just like the Asian countries that keep their currencies weak so they can import into the United States… The U.K. is loving this weaker pound sterling versus the euro.

“This is not a ‘one and done’ for the BOE either… I see many more rate cuts in their future, since now I know ‘how they are’! I would look for a couple more rate cuts before we hit warm weather next year…”

Doesn’t sound too good for the pound sterling, but Trichet’s speech should give the euro support going forward. Chuck mentioned Trichet’s hawkish tone at his press conference, and I want to give readers a little more detail on what he said. Trichet threatened to raise interest rates if an oil-driven jump in inflation spurs pay increases. There is “strong short-term upward pressure on inflation,” according to Trichet. The ECB “will not tolerate second round effects” on wages and some policy makers wanted to raise rates as early as today. I don’t think there is any doubt where the ECB is taking rates. They are not on the same page as the BOE or the U.S. Fed, and I would look for higher rates in Europe to continue to support a stronger euro.

Today the markets are watching and waiting for the release of the monthly employment data. As Chuck wrote yesterday, the ADP report has got investors all primed for a surprise increase in U.S. employment. Even if we get a ‘pop’ in monthly employment, neither Chuck nor I think this will signal a bottoming of the U.S. economic problems. I expect the markets to have gotten ahead of themselves after the ADP surprise, and the dollar will likely get sold after today’s employment figures are announced.

Currencies today: A$.8755, kiwi .7771, C$ .9959, euro 1.4635, sterling 2.0319, Swiss .8844, ISK 61.44, rand 6.7232, krone 5.4789, SEK 6.4286, forint 172.35, zloty 2.4493, koruna 17.8843, yen 111.57, baht 30.33, sing 1.4408, HKD 7.7958, INR 39.405, China 7.4050, pesos 10.8174, BRL 1.7668, dollar index 76.287, Silver $14.446, and Gold… $800.40

That’s it for today…This will probably be a little late in getting to you this morning as I had problems with my computer. Thank goodness it is a Friday! We continue to be extremely busy on the desk with investors beating down the doors to get their investments diversified outside the dollar. I just have to wonder where all of these people have been over the past few years? Oh well, better late than never! In Chuck’s words, have a Fantastico Friday and a Wonderful Weekend!!!

Chuck Butler
December 7, 2007

The Daily Reckoning