Paulson Throws the Markets a Curve

Good day… Chuck is out today, so I get the opportunity to share some of my thoughts on the markets. As many of you know, I spent most of last week in Washington D.C. giving presentations at the Money Show. On the way to the hotel, the cab driver – who had noticed my EverBank luggage tag – asked if I was a banker. He said he had seen a lot of us lately. I guess I was one of the few bankers flying into Washington D.C. who wasn’t heading over to the Treasury Dept. to get some of the cheap money they are passing out. I had a great trip to Washington and really enjoyed the opportunity to spread the word about EverBank and the protection that portfolio diversification provides.

I don’t think Treasury Secretary Paulson is having as good a time as I did in the nation’s capital. When he came down from NY a couple years ago to take over the Treasury, he was Wall Street’s best-paid CEO and looked to cap his career with a high-profile sojourn in public service. But his credibility has really taken a hit over the past year, and his update before congress yesterday didn’t quite go as everyone expected. Chuck left me the following to share with readers this morning:

“Yesterday I told you that Treasury Secretary Paulson was going to give an update on the bailout package… And instead of an update, he threw the markets a great big 12-6 curveball! Treasury Secretary Paulson laid out his plans for the next stage of the financial market rescue package, announcing that he has shelved a plan to buy troubled mortgage assets and is moving his attention to non-banks and consumer finance.

“And… In a striking admission, Paulson said that buying mortgage assets ‘is not the most effective way’ to use government funding. Geez Louise! I could have saved him, Congress, and the whole country a lot of time and stress on this if he would have just listened to me at the time! I said when it was first announced that the government had no business buying up these troubled assets, and getting involved in what used to be known as ‘free markets’! He’s changing horses in the middle of the stream! What gives? And… All this unknown stuff now, put the trading theme into overdrive, buying dollars in the deep, dark days of the U.S. economy!

“There’s a silver lining here folks… And I believe that Secretary Paulson is seeing the seized up credit markets unlock. This development might just be nascent, but he believes it’s there. And when this problem with the credit markets eases, a return to the fundamentals could very well be in store. In fact, I would bet a dollar to a Krispy Kreme, those fundamentals are going to come home to roost once this credit market problem is in our rear view mirror.

“Now, back to the bailout package… Now, the Treasury Secretary wants to put the government’s money toward unlocking student loans, credit card receivables, and auto loans… Some are calling this move a U-Turn, but in essence it isn’t. Before the government was going to buy toxic bonds made up of residential home loans… Now, they will be buying bonds made up of consumer loans, which in my opinion may end up more toxic than the first choice, given the fact that we’re in a recession and the recession will work out to be one that is protracted.

“While these things ‘might’ get the credit markets unlocked, they might miss the mark too, and until we get these credit markets unlocked, the markets’ focus will remain on the crisis and not return to focusing on the awful fundamentals in the U.S. economy. These awful fundamentals need to rise to the top again for risk takers to come back, and until the risk takers come back, currencies and commodities like euros (EUR) and gold, will continue to be put into a corner by the dollar.

“We get a new Treasury Secretary in January when the new administration takes over. The new Treasury Secretary will have their hands full, for sure!

“On the side… OK…. Yesterday morning… I looked up to the TV and saw that knucklehead Jim Cramer on the Today Show. I swear… He said this to Meredith… “I have been honest on this show, Meredith, and I ‘try’ to be honest on my show”. He tries to be honest? OMG!”

I agree with Chuck, whoever decides to take over as the new Treasury Secretary will certainly have their work cut out for them. I’ve heard that they might bring back Volker to take over for Paulson. That would be an interesting choice, as he has ‘been there, done that’ – crushing inflation during the 1980s. But the high interest rate policies that he pushed caused the United States to dip into a deep recession; and he also played an important role in bringing the U.S. off the gold standard back in the early ’70s. Even if he doesn’t take the Treasury position, Volcker is one of Obama’s advisors, and will certainly have some influence on the new administration’s monetary policies.

Paulson’s curveball put the markets in a sell mode, with investors moving back into the relative safety of U.S. treasuries and money markets. The dollar strengthened after his bombshell, but started to fall again in Asian trading. The Japanese yen (JPY), which has been one of the most volatile currencies, rose to a two-week high against the euro after Paulson’s curve caused cuts in purchases of higher-yielding assets. But the yen reversed some of yesterday’s sharp gains overnight as currency traders worried about BOJ intervention. These concerns were heightened by comments from Japanese Finance Minister Nakagawa who warned that Japan would protect the yen against sharp volatility.

Despite the prospect of intervention, the yen remains a buy according to a report by Goldman Sachs group. Goldman believes the yen will strengthen 6% against the U.S. dollar due to a continued unwinding of the carry trade. The dollar will weaken to 90 yen in three months, before gaining to 100 yen six months from now, Goldman said. “Deleveraging and funding constraints have likely created a new source of foreign-exchange demand and supply,” the Goldman analyst wrote. “We expect deleveraging patterns to continue into year-end, driving the dollar and yen stronger and putting pressure on higher-yielding currencies.” As readers know, Chuck has been talking about this carry trade reversal for some time, and we agree that this reversal will likely last through the end of the year and into the 1st or 2nd quarter of 2009. Look for further dollar strength during this time period, but watch out below once the dollar reverses course.

The reversal of the carry trades has led to a fall in the value of the Australian dollar (AUD), a move that accelerated yesterday. The currency drop became too much to bear for the Reserve Bank of Australia, who intervened in the markets to protect the Aussie dollar. An RBA spokesman confirmed the central bank bought its own currency, putting a floor under the currency after it dropped over 2 cents yesterday morning. This intervention is a good sign that the RBA is now concerned with the value of the Aussie dollar and won’t let it slip too much further than the current levels. With the RBA’s support, and the possibility of a bottoming of commodity prices, these could be excellent levels to buy into the Australian dollar.

The German economy (Europe’s largest) contracted more than economists expected in the third quarter, pushing the nation into the worst recession in at least 12 years. German GDP dropped a seasonally adjusted 0.5% from the second quarter, when it fell 0.4%. The economy is officially in a recession, as it has now contracted over two consecutive quarters. Traders increased bets that the ECB would reduce interest rates. The euro had been sold off before the announcement, hitting a low of 1.2389 versus the U.S. dollar, but then rallied back above $1.25 in early U.S. trading.

This week has been a pretty slow data week here in the United States, but today we have two important releases. The U.S. trade deficit probably narrowed in September as retreating oil prices reduced the value of imports. The sharp increase in the value of the U.S. dollar over the past six months has also helped reduce our trade deficits. But I don’t think the commodity price slump will last; and I also believe that the U.S. dollar will turn back around sometime next year. So this narrowing of the trade deficit won’t last. We will also get the weekly jobs report today, which will likely show another big bounce in first time filings for unemployment. The labor market in the United States is bad and getting worse, and I would be surprised to see a number below 500K for the weekly initial jobless claims. This is one of the factors that caused the Treasury Secretary to reverse course on the bank bailout, as he now moves his focus to the growing consumer credit crisis.

We talked about China’s big stimulus package earlier this week, and the impact it will have on China’s U.S. dollar reserves. But the stimulus package will have another impact on the markets. Most of the $586 billion stimulus will be focused on infrastructure building projects. These projects will mean China will continue to import large amounts of copper, iron ore, cement, and other building materials. They will also continue to demand a greater supply of oil and fuel. This new demand will help offset some of the drop in commodity demand from the slowing western economies. Commodity prices have fallen dramatically as traders priced in the global slowdown. But China’s economy is still the fastest growing among the world’s 20 largest, with a growth rate close to 8%, and this latest stimulus announcement should cause a bounce back in the prices of these commodities. The countries supplying China with raw materials should also benefit, including the currencies of Brazil (BRL), Australia, and Canada (CAD), all of which have been beaten down lately.

Finally, Chuck let me know some great news for our St. Louis readers: There’s going to be a screening of Addison Wiggin and Kate Incontrera’s movie, I.O.U.S.A. here in town… The screening will be November 18 at the Missouri History Museum, part of the Community Cinema Series, co-sponsored by KETC and the History Museum. I.O.U.S.A. will be shown at 7 PM, followed by a panel discussion.

Currencies today 11/13/08: A$ .6389, kiwi .5557, C$ .8113, euro 1.2535, sterling 1.4838, Swiss .8404, ISK (No Quote), rand 10.3166, krone 7.096, SEK 8.0703, forint 215.51, zloty 2.9765, koruna 20.095, yen 96.03, baht 34.99, sing 1.5119, HKD 7.7501, INR 49.2925, China 6.8298, pesos 12.97, BRL 2.305, dollar index 87.43, Oil $56.81, Silver $9.41, and Gold… $717.66

That’s it for today… Got to go now so I can call into the quarterly EverBank officer’s meeting. It really is great working for EverBank, we continue to do very well and maintain our health in a very difficult banking environment. We just announced record growth in deposits and earnings here at EverBank, so it truly is a great day!! Hope everyone has a Tub-thumpin Thursday!!

Chris Gaffney
November 13, 2008

The Daily Reckoning