Rescue Plan Not an Instant Fix

St Louis, Missouri- Good day… Another roller coaster of a day yesterday, as the dollar continued to slide through lunch but then rallied back up in the afternoon. As I walked out the door last night, most of the major currencies were trading right about where they were when I turned the screens on. The dollar has started to fall again in overnight trading, so the up and down of the past few weeks looks to continue.

The news stories coming across the wires this morning seem to be as volatile as the currencies. I have now counted three different stories stating that the markets are moving back into higher yielding currencies and riskier investments after the coordinated bank bailout plan that was announced yesterday. But several other stories are talking about how investors are moving out of the higher yielding assets because of concern that the bank rescue will take too much time to unfreeze global credit markets. I tend to agree with the latter of these.

While Paulson and Bernanke have shown a willingness to throw UNLIMITED U.S. dollars at the credit markets, they have very little leverage to make the banks start lending again. The equity stakes which the U.S. taxpayers purchased in Citigroup, Morgan Stanley, and seven other big institutions come with no guarantee that the investments will spur lending. Nor do they give the government board seats or any other leverage to demand that the firms actually use the money to help the economy. The banks have accepted the money (they may be dumb but they aren’t stupid) and look to be using it to help shore up their balance sheets. The bet Paulson is thinking that by helping them get their balance sheets in order more quickly, the taxpayer investments will hasten the major banks return to a more normalized lending environment. And I agree that this will probably be the case, but this will not happen overnight, and the recession that the United States slipped into several months ago will continue to deepen.

Chuck had this to say about yesterday’s trading:

“Well… All the euphoria in the markets earlier this week is diminishing, as the realization that all this work to unlock the credit markets does NOTHING to change the recessionary course of the economy. San Francisco Federal Reserve Bank President, Janet Yellen, did not help sentiment when she said, ‘the U.S. economy “appears to be in a recession” as a contraction of growth is likely in Q4 and that financial market turmoil is a “serious and direct threat to global well being.”‘

“This was a big theme in my talks, not only here in St. Louis yesterday, but Monday in Chicago to the trading theme that I’ve talked about dominating currencies… But when the credit markets get unlocked… We’ll return to the underlying fundamentals. And the recession that could last four quarters – according to one of my fave economists, Nouriel Roubini – is one of those awful underlying fundamentals… Yes, the dollar has rallied at times during previous recessions… But, we never had all these other dark clouds hanging over us like we do this time… Debt coming our out ears, money supply like there’s no tomorrow, ultra-low interest rates that are very likely to go even lower, and now our new ‘socialism’ hard at work! There are more… But, my fat fingers get tired after a while! HA! OK… Off to Philly!”

ECB President Trichet suggested a return to the ‘discipline’ of Bretton Woods yesterday in a speech at the Economic Club of New York. “Perhaps what we need is to go back to the first Bretton Woods, to go back to discipline,” Trichet said. “It’s absolutely clear that financial markets need discipline: macroeconomic discipline, monetary discipline, market discipline.” The data released yesterday here in the United States illustrates the need for monetary discipline in our own government.

It is of no surprise that the U.S. government posted a record budget deficit for 2008 as financial market strains slowed the economic growth, and spending rose the most since 1990. The shortfall widened to $455 billion in the fiscal year ended September 30, compared with a $162 billion deficit a year earlier and the previous high of $413 billion in 2004. The gap was 3.2% of GDP, up from 1.2% last year. And with the bailout and ‘rescue’ plans that Bernanke and Paulson have recently concocted, the shortfall will likely quadruple to about $2 trillion in the coming year. Yes, we will likely have a budget deficit of nearly $2 trillion in fiscal 2009!!

With this kind of debt, there is just no way the dollar will hold on to its value. A reader sent me a very scary looking graph yesterday, and I would love to share it with you but I haven’t figured out how to paste it in. It illustrated the money supply figures and how they have spiked here in the past few weeks. With the Treasury secretary and Fed Reserve chairman throwing an unlimited supply of dollars into the markets, the value of our U.S. dollar will undoubtedly be debased.

Today we will get a peek at how the U.S. economy is weathering this storm, as retail sales and producer price data is released along with the empire manufacturing data and business inventories. Later this afternoon we will get a glimpse at the Fed’s Beige Book which gives the regional Federal Reserve bank’s take on the current situation. Sales at U.S. retailers probably decreased in September as mounting job losses, plunging home prices, and the deepening credit crisis rattled consumers. Producer prices may be a small bright spot, as the drop in the price of oil helped bring down producer prices in September.

Britain’s pound (GBP ) had its biggest two-day gain in three years against the dollar, as U.K. stocks advanced after the government bailed out three of the U.K.’s major banks. The currency climbed to the highest level versus the dollar in almost a week, as the FTSE stock index rose 3% yesterday. The pound is seeing a bit of a bounce back, but their problems are very similar to what we have here in the United States, and I would suggest taking advantage of any bounces to exit pound sterling positions. There will be more bad news to come in the United Kingdom.

The Japanese yen (JPY ) rose for the first time in five days versus the dollar, as investors recovered from their initial euphoria over the bank bailouts. The bailout announcement has provided a bit of stabilization to the markets, but now investors are again shifting their focus to fundamentals, which are not pointing to strong global growth. Carry trade investments, which were put on during the euphoria are being taken back off again as investors realize the rescue plan will not be an immediate cure for the global economic downturn. The yen is also being underpinned by repatriation of funds by Japanese investors. Japanese households’ appetite for risk was already diminishing before the turmoil last week materialized, and these investors continue to bring their money back home.

With the markets waking back up to the fact that there is still risk in these markets, the higher yielding currencies of South African rand (ZAR ) and Mexican pesos (MXN ) sold off. The Australian dollar (AUD ) and New Zealand dollars (NZD ) also fell, as stocks and commodity prices declined on global economic concerns. The retreat of the Aussie dollar after yesterday’s record gain was somewhat expected. Gold, Australia’s third-most valuable raw material export, dropped for a fourth session along with other commodity prices. Prime minister Rudd continues to take an aggressive approach to addressing the credit crisis, stating that Australia’s financial system and economy remain ‘strong’.

The Brazilian real (BRL ) bucked the trend of other high yielding currencies and rose slightly for a second day. Brazil’s central bank announced that it was selling dollars in the spot market yesterday in order to support the real. Later, the authority said that it would sell up to $1 billion worth of U.S. dollars at auction today. The real has risen nearly 8.5% versus the U.S. dollar in the past few days, nearly erasing last week’s plunge.

Canada’s currency (CAD ) weakened against the U.S. dollar as the price of crude oil fell. The Canadian dollar has declined 13% since July 11, when oil reached a record of $147.27 a barrel. Commodities make up about half of Canada’s export revenue, and the United States is Canada’s largest trading partner. With the U.S. obviously slipping deeper into recession, the Canadian dollar will find it tough to sustain any kind of rally. They have established close trading ties with Asia and China in particular, which will likely make up for some of the lost exports to the United States. These trading ties and the abundance of commodities in Canada could help put a floor under the loonie.

I will close today’s Pfennig with another update on the situation in Iceland. Iceland’s central bank cut its benchmark interest rate by 3.5% points following the collapse of the country’s three largest banks. Policy makers agreed on the cut at an unscheduled meeting today following the collapse of three banks last week. The central bank abandoned its attempt to peg the currency to the euro (EUR ) last week, citing ‘insufficient support’ from the market. We will continue to keep investors updated as to the status of things in Iceland.

Currencies today 10/15/08: A$ .7023, kiwi .6235, C$ .8627, euro 1.3659, sterling 1.7544, Swiss .8815, ISK 260.0, rand 9.2343, krone 6.2831, SEK 7.1762, forint 192.22, zloty 2.5739, koruna 18.1005, yen 101.38, baht 34.13, sing 1.4688, HKD 7.7594, INR 48.47, China 6.8318, pesos 12.442, BRL 2.0963, dollar index 81.158, Oil $77.39, Silver $10.889, and Gold… $845.35

That’s it for today…Another crazy day on the desk yesterday, with near record call volumes. Customers are both buying and selling currencies; I guess that is what makes markets! Chuck said his presentation went well here in St. Louis and he is on his way to Philly today. Should be another busy day today, so off to the phones! Hope everyone has a Wonderful Wednesday!!

Chris Gaffney
October 15, 2008

The Daily Reckoning