America Gets a Margin Call
By Bob Wong, Vice President - July 29
Since the late 1970’s Congress has pursued deregulation of U.S. financial markets to improve the competitiveness of commerce and banking. In the shadow of the ‘87 stock market crash shortly after becoming Chairman of the Federal Reserve, Alan Greenspan re-affirmed America’s faith in the market’s invisible hand to best allocate scarce resources of the economy and quell the occasional financial crisis. Adopting the mantra of expanding home ownership under successive administrations, he endorsed credit creation via non-traditional conduits and financial engineering of complex mortgage based investments, the unraveling of which has roiled global financial markets. In the past decade, credit creation has evolved to become no longer the sole domain of commercial banks through multiple expansion of demand deposits. Investment banks, mortgage lenders, brokers, credit card companies, finance and leasing companies, department stores, etc. all extend credit. Together, credit and consumption have become the twin pillars of the U.S. economy. Unprecedented levels of mortgage and consumer debt mirror breathtaking levels of public debt, spurred on by reckless deficit spending under the Bush administration.
As a continuing reminder that the mortgage debacle and credit crisis are far from over, recent deterioration of balance sheets at Fannie Mae and Freddie Mac, the nation’s largest mortgage lenders, have necessitated a massive federal rescue package. Emergency funding from the Federal Reserve has been made available to both institutions, with Treasury seeking congressional approval to purchase shares of both GSEs on the open market. To top off the string of bad news this month, Indymac Bank of California has been taken over by the FDIC, after the bank reported to federal regulators that it was no longer well capitalized. Skittish depositors apparently withdrew more than $1.2B of deposits after learning about potential large losses from its sub-prime mortgages.
At the end of May the FDIC reported about 90 banks in trouble but Indymac Bank was not even on the list. Admittedly this number pales in comparison to the 1,200 banks and thrifts shut down during the savings & loans crisis. However, the current mortgage meltdown together with high energy prices, rising unemployment, sinking stock markets, massive budget deficits, record consumer debt, a weak US Dollar and resurgent inflationary pressures are seriously limiting the effectiveness of policy actions to shore up the financial system. The political reality of an election year is further complicating the situation, as gridlock will certainly prevail in Congress until after the November elections. While politicians and economists debate whether the U.S. is in a real or mental recession, it is clear that many policy makers do not even grasp the magnitude of the problems facing the country today.
The coming recession will be unlike any past typical business cycle downturn that can be countered with traditional fiscal and monetary stimulus measures. Instead, the culmination of numerous structural imbalances, which have been allowed to fester, will manifest in a painful and drawn out economic adjustment brought on by the necessary de-leveraging of the entire credit-fuelled financial system. This major upheaval will result in lower economic growth and eventually outright economic contraction, leading to a profound reduction in the standard of living in America for years to come. The pattern of conspicuous consumption encouraged by easy and available credit will come to a screeching halt. Corporate leveraged buyouts will become a thing of the past as banks facing billions in writedowns retrench. As home prices continue to fall, some analysts forecast the total mortgage related writedowns could approach $1.5T. With the value of home equity, mortgage portfolios and mortgaged-backed securities vaporized by the plunging market, highly leveraged homeowners, lenders and mortgage investors are forced to liquidate or raise additional capital in a textbook margin call scenario.
In a low interest rate environment, financial institutions benefit from a positively sloped yield curve. Governments at the state and federal levels also save significant amounts of interest payment on new bond issuance. It has long been accepted gospel that cheap and readily available credit is an essential ingredient of economic growth. However, the current financial crisis has also revealed that prolonged periods of unwarranted low interest rates have the undesirable effect of deterring savings and encouraging speculation. Savers are punished. Conservative investors including pension funds can no longer rely solely on yields from government bonds to secure a reasonable rate of return. Subverting the intent to promote economic growth by encouraging corporations to borrow and invest in their businesses, much of the excess liquidity often finds its way into speculative bubbles. Meanwhile, meager, inflation-eroded returns provided by bank CDs, U.S.Treasuries and savings accounts force many traditionally risk averse savers to risk their life savings and speculate in the stock market, often with disastrous results.
With the federal budget deficit already bloated under the weight of war expenditures, recently announced consumer stimulus and homeowner rescue packages further undermine confidence in the US Dollar. Yet this has not dampened the enthusiasm of many in Congress to either make permanent the Bush tax cuts or to pass new middle class tax cuts to pacify voters. The trade deficit situation is no less precarious. On energy imports alone, the U.S. will send $700B to oil producing countries for 2008, which more than offsets the positive impact of higher exports made possible from a weaker dollar. Indeed, Chairman Bernanke finds himself in the unenviable position of having to wage war on two fronts; he has to keep rates low to help financial institutions, homeowners and consumers weather the mortgage and credit crises, yet keeping rates low in the teeth of surging inflation further erodes the value of the US Dollar, fuelling inflation of import prices of which energy is a large component.
In fact, a new school of thought emerging in the currency market is that crude oil has become another anti-US Dollar currency/commodity like the Euro or Gold. While multiple economic factors, financial flows and investor expectations impact the value of the dollar on a daily basis, a linkage has recently appeared between the US Dollar and crude oil, albeit tenuous and without causality firmly established. We caution that the fickle currency market habitually disappoints those who try to draw any long term conclusion from transitory characteristics of particular currencies. For example, the Japanese Yen and Swiss Franc that used to be barometers of risk appetite have in recent weeks assumed new personalities. The Canadian Dollar that was heralded in 2007 as a petrocurrency and beneficiary of a strong resource sector has lost its luster in 2008, despite continuing gains in commodities.
In a larger context, it is still an open debate whether the perennially weak dollar is to be blamed for the surge in commodity prices, or whether strong commodity prices are reinforcing the view that the dollar is weak. There is, however, consensus among economists that excessive money supply growth from major global central banks (through interest rate ease and hike cycles) has been a major contributing factor to rising commodity prices. As OPEC, oil companies and assorted evil speculators become less convincing villains behind the rise of crude oil, the weak US Dollar is carted out before the town square to receive its public flogging. As for assigning blame for the predicament of the US Dollar, politicians on Capitol Hill will surely waste no time in finding the next scapegoat, instead of pinning the blame squarely on the inflationary policies of the fed, and the insatiable appetite of Congress to borrow from future generations.
With recent releases painting an increasingly dismal picture of economic performance in the Euro zone, it is no longer a foregone conclusion that the Euro currency will continue to benefit from a weak US Dollar without breaking a sweat. As the U.S. stumbles from one financial wreck-up to another while damage to European financial institutions remains relatively contained, the interest rate differential between the two economies will favor the Euro zone for the foreseeable future. It is a common perception that the European Central Bank’s mandate to single-mindedly focus on price stability is an easier task compared with the juggling act that the Fed has to perform between fostering growth and fighting inflation. However, it would be imprudent to assume that the ECB can tighten rates further without exacting a severe toll on the economic growth of Euro zone countries, eventually leading to diminished prospects for the Euro currency.
The recent retreat in oil prices has provided some hope for those in the US Dollar bull camp. However, this hope is predicated on an assumption of cause and effect which remains a subject of debate. Our view is that oil prices are primarily a function of supply and demand of energy, and the fate of the US Dollar is hostage to the current account deficit and the general health of the financial system. Unfortunately this is not a view shared by those in Congress who are convinced that everything would be fine if only they could banish speculators from ever again buying another barrel of oil or shorting another share of Fannie Mae.
If you would like to learn more about FX strategies please contact Bob Wong at 905-771-5854.
The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable. Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors. Please carefully consider your financial condition prior to making any investments.
