Subprime Mess Claims Another Victim

Good day… And welcome to what should turn out to be a pretty exciting week in the currency markets. In stark contrast to last week’s lack of events, this week will bring us a flurry of economic data, capped off by the FOMC meeting on Thursday. We start the week with existing home sales in the United States, which should not give much support to the dollar. Tomorrow will be more bad news for the greenback, as we will get more data on the U.S. housing market (new home sales) along with consumer confidence and the Richmond Fed Manufacturing Index. None of this data is expected to be positive, so look for further dollar weakness.

I happened across a story in Saturday’s NY Times that highlights just how bad the subprime mortgage mess could get. On Friday, Bear Stearns (NYSE:BSC), the major Wall Street Investment bank, pledged up to $3.2 billion in loans to bail out one of its hedge funds that was collapsing because of bad bets on subprime mortgages. It was the biggest rescue of a hedge fund since the 1998 bailout of Long-Term Capital Management.

Here is what the NY Times had to say: “The crisis this week from the near collapse of two hedge funds managed by Bear Stearns stems directly from the slumping housing market and the fallout from loose lending practices that showered money on people with weak, or subprime, credit, leaving many of them struggling to stay in their homes.

“Bear Stearns averted a meltdown this time, but if delinquencies and defaults on subprime loans surge, Wall Street firms, hedge funds and pension funds could be left holding billions of dollars in bonds and securities backed by loans that are quickly losing their value.

“The firm is, meanwhile, negotiating with banks to rescue the second, larger fund started last August, which has more than $6 billion in loans and reportedly holds far riskier investments. Those negotiations were continuing yesterday, and it was unclear whether they would be successful.”

I don’t want to belabor the very obvious point, but the effects of the housing slowdown are just beginning to show up. Unfortunately we will continue to see more fallout from the subprime mortgage mess. You won’t be able to say we didn’t warn you. Protect yourself by moving a portion of your assets outside the U.S. dollar.

Good news out of Germany should help the euro (EUR) gain ground versus the dollar. German consumer confidence rose to a six-month high. The improvement suggests consumer spending may increasingly contribute to economic expansion. Growth in the euro region has so far been driven by exports and company investment. That has pushed the unemployment rate to a six-year low of 9.2%. Consumers finally trust that unemployment is coming down, and seem willing to start spending, which will support growth in Germany.

This rise in consumer confidence plays right into the ECB’s indications that they are not done raising rates. “We have never said that the tightening cycle has ended,” Quaden told reporters today in Basel, Switzerland, where he is attending a meeting of policy makers from around the world. “Central banks have to closely monitor risks for inflation, which seem to be oriented upwards. It’s in particular a job of the ECB.”

A report by the Bank for International Settlements agrees with Quaden’s assessment. The report, released at the same meeting in Basel (what a great place for a meeting in mid-summer!) stated that central banks will need to continue raising interest rates to quell inflation. “Inflationary pressures might turn out to be more significant than anticipated. Authorities should continue gradually to normalize the level of policy interest rates”.

While interest rates are expected to continue to rise in Europe and Asia, U.S. rates will likely stay right where they are. Unfortunately, the FOMC will be unable to respond to rising inflation with an interest rate increase for fear of worsening the housing slump. The mortgage mess has all but tied the hands of the boys and girls at the Fed. If the housing data come in as expected, the FOMC will have to keep rates where they are during their meeting on Thursday. As we have continually warned, the Fed has backed itself into a corner and will just have to sit tight and hope the U.S. economy can navigate itself through what will be some very troubled waters.

The Swiss franc (CHF) was one of the best performing currencies at the end of last week, as carry trade investors started to lighten up their positions. As we have discussed in past issues of the Pfennig, the carry trade works best in a fairly stable investment environment. As volatility in the markets increase, the costs associated with these trades grow and the investors begin to rethink their positions. A reversal of this carry trade will continue to help the Swiss franc outperform many of its European neighbors.

Looking through the papers this weekend, it is brutally apparent that the world today is much more volatile than it has been over the past several years. This increase in volatility will eventually filter into the investment markets where risk has been all but ignored as of late. Sometime in the near future, I believe investors will again start to move away from these risky assets and move at least some of these funds back into investments that are typically seen as safe havens. Precious metals are one such safe haven and should benefit from this move away from risk. Gold and silver could make another major move up after spending the last year trading in a fairly tight range. We continue to offer investments in gold and silver through our Metal Select accounts, and will be announcing a new way to invest into silver fairly soon. On that little tease I will move on to the currency wrap-up.

Currencies today: A$ .8487, kiwi .7660, C$ .9332, euro 1.3458, sterling 1.9983, Swiss .8139, ISK 62.77, rand 7.1561, krone 5.9456, SEK 6.8661, forint 183.27, zloty 2.8156, koruna 21.36, yen 123.46, sing 1.5380, HKD 7.8128, INR 40.87, China 7.6193, pesos 10.8253, dollar index 82.33, Silver $12.95, and Gold… $650.90

That’s it for today… Had a great weekend here in St Louis as I got to watch the Cardinals finally beat the Phillies in the new Busch Stadium. The Phillies were the only team the Cards hadn’t beaten in the new stadium, so everyone was excited to see it finally happen on Saturday. Our Jennifer just walked in, so no baby yet. I predicted she would have it tomorrow, so my $2 investment in the “baby pool” is still looking good. Hope everyone has a great start to their week!

Chuck Butler — June 25, 2007

The Daily Reckoning