The Fed Floods the Markets with U.S. Dollars

St Louis, Missouri- Good day…and Happy Columbus Day! This is an official bank holiday here in the states, so all of the banks are closed – but the stock markets are open. We will have a half-day here on the desk to try and catch up with all of the work, which has been piling up the past few weeks. The phones are turned off, since it is an official bank holiday, but we will be checking messages, and we’ll try to get back to everyone as quickly as possible. It is a very unusual holiday, as the banks are all closed with no fund transfers possible, but the stock markets are open. Currency desks are lightly staffed, so we will have to really work to get the trades done this morning. These strange holidays can lead to some real market volatility, so today will probably be another rollercoaster.

In an all-out effort to ease the credit freeze, the Federal Reserve recruited help from the ECB, Bank of England, and the Swiss central bank to flood the market with U.S. dollars. These central banks will auction unlimited dollar funds with maturities of seven days, 28 days, and 84 days at a fixed interest rate. This move is unprecedented, as all previous dollar swaps were capped at a maximum amount while these auctions will be for unlimited funds.

Chuck spoke about these dollar swaps a few weeks ago, explaining that these trades partially account for the huge rally in the U.S. dollar. Central banks around the world are purchasing U.S. dollars to lend out to the markets, at the request of the Federal Reserve.

Policy makers from the G-7 pledged this weekend to take "all necessary steps" to stem the markets’ dramatic slide. European leaders agreed to guarantee new bank debt and use taxpayer money to keep distressed lenders afloat after the worst rout in the European stock markets in two decades. But they didn’t come up with any coordinated measures, other than saying they need to attach the crisis on a unilateral basis.

Chuck had this to say about the G-7 and G-20 weekend meetings:

"The G-7, G-20 meetings didn’t leave the markets much to go on. They issued a communiqué that said they would take the ‘necessary steps to stem Global Financial Crisis’… I would think that the markets were looking for something with a little more meat to it, don’t you? I doubt the credit markets are going to magically unlock on that communiqué… And so the beat goes on…"

The euro (EUR ) rose the most in three weeks against the dollar in early European trading, moving up over 3 cents from Friday’s low of 1.3259. The British pound (GBP ) also advanced against the dollar on speculation that the government’s bailout plan will avert a banking collapse. In the near term, the plans give investors confidence that there won’t be further banking failures. In today’s world, everyone is constantly looking for where the next big financial failure will occur, so the European plan to shore up their banks has led to a pretty good rally in the euro and pound sterling.

The Japanese yen (JPY ), which has been the best currency year-to-date, traded in a rather tight range – right around 100 yen per dollar. Some currency research departments are now suggesting that the yen will rally all the way to 95 as investors reverse carry trades. With the global slump in equities, Japanese investors have started selling some of their more-than $1.3 trillion in overseas assets to bring money home. Chuck mentioned that he had seen this before, and wanted me to share the following with readers this morning:

"It has been a very tumultuous week, and I just want to make certain that you are aware of the trading pattern that is existing these days. It is Japan circa 1995-1998, when the Japanese stimulus packages and budget junk didn’t work, and the economy was circling the bowl. But… The yen was rallying to 85! It was a repatriation of the offshore investments to bring home to squirrel away and have ‘under the mattress’ in case things got even bleaker.

"Sound familiar? That’s what’s going on right now with the dollar… It’s a ‘the worse things get in the U.S., buy the dollar, and if it looks like Armageddon won’t happen in the U.S., sell the dollar’ trend… Nothing more, nothing less…"

Two of the biggest movers over the weekend were the high yielding currencies of Brazil (BRL ), New Zealand (NZD ), and South African rand (ZAR ). The Brazilian real was the biggest mover, up over 5% versus the U.S. dollar in the past 24 hours. The rebound in stock markets overseas has made investors more comfortable with moving money back into the emerging markets. But this rally could be short-lived, as the reality of a global recession sinks in and investors continue to de-leverage their positions. At this point I think it is best to take advantage of rallies in the high yielders to exit and reallocate funds into more ‘stable’ currencies.

Two that would fit this description are the Norwegian (NOK ) and Swedish (SEK ) currencies, which rose against the euro and the dollar on this weekend’s news. But these gains could again prove short lived, as Norway’s central bank is expected to lower interest rates later this week. The Norges Bank pushed forward its regular interest-rate meeting from October 29 to October 15. The bank kept borrowing costs on hold last week while Sweden’s Riksbank cut its main rate a half point as part of a coordinated effort by central banks, including the ECB, to revive interbank lending.

The Australian dollar (AUD ) also rallied overnight, moving up over 4.5% versus the U.S. dollar in European trading. The Australian dollar rose as Prime Minister Kevin Rudd said yesterday that his government would guarantee all deposits with financial institutions for the next three years to bolster confidence in the banking system. The government will also guarantee all "term wholesale funding" by Australian banks operating in international credit markets. This was an aggressive move by the Australian government to stem the run on the Aussie dollar, and right now it seems to be working. With just a small amount of confidence creeping back into the markets, some investors are actually moving money back into the ‘carry trades’ which have benefited the high yielding Aussie dollar and New Zealand dollar over the past few years. Investors should not count on any ‘carry trade’ rallies to last, as these investors have proven to be extremely volatile over the past year.

But we are possibly seeing an end to the all-out attack on the Aussie dollar that has occurred over the past few months. If the latest move by Prime Minister Rudd works, we should see the Aussie dollar start to slowly gain back some of the recent losses. Australia continues to have excellent commodity resources, and a direct trading link to China and the rest of Asia.

And I will close out today’s Pfennig with another update on the Icelandic krona (ISK ). Trading in Iceland’s krona all but dried up last wee as the country’s banks collapsed, sending the currency’s bid/ask spreads skyrocketing. There is currently no active market for the Icelandic krona, and trades are very difficult to get through. JP Morgan Chase & Co. was reported to be in negotiations with Iceland’s central bank to underwrite all krona trades in an attempt to unlock the currency markets, according to TD Securities in London. We continue to attempt to close out the Icelandic krona CDs as they come due, and will use every effort to get investors in this currency traded back into U.S. dollar. We were able to get the Icelandic currency traded last week and expect to be able to again this week, but can’t make any guarantees. We will continue to keep you updated on the status of these very volatile markets.

Now on to the Big Finish…

Currencies today 10/13/08: A$ .6693, kiwi .6044, C$ .8572, euro 1.3620, sterling 1.7332, Swiss .8845, ISK (no quote), rand 9.2399, krone 6.1787, SEK 7.0841, forint 185.28, zloty 2.6036, koruna 18.102, yen 100.46, baht 34.26, sing 1.4695, HKD 7.7636, INR 48.26, China 6.8258, pesos 12.6735, BRL 2.313, dollar index 81.18, Oil $82.24, Silver $10.535, and Gold… $850.40

That’s it for today… Chuck and I switched spots today, as I returned from running the Chicago marathon, and he headed up for the FX University. The marathon went well, but I missed a personal best by a little under a minute. The weather was a little hotter than I like, with temperatures at the finish line up over 80. But no complaints or excuses from me, I still ran a sub 4-hour marathon, which was just fine with me. Chuck returns back to St. Louis tonight, as the FX University comes to St. Louis tomorrow.

Chris Gaffney
October 13, 2008

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