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Tuesday, March 18, 2008

What Happens Next?

By Claus Vistesen Copenhagen

[Update Added Below: Did Bernanke dissappoint markets? 'Only' 75 basis points.]

As the ever succinct Macro Man pointed out yesterday the current situation is not one in which the Devil goes to Georgia to play the fiddle over Johnny's soul but more like Lucifer and his kin scouring the big Street in NYC to claim their due in the form of over leveraged traders' and institutions' souls. Obviously, the Street has called in their favorite exorcist in the form of Ben Bernanke but it appears, at this point in time, that the legions from below might just be on the winning side on this one. Markets in general are in complete "shock and awe" mode at the moment on the back of the demise of Bear Stearns and the subsequent buy-out by JPMorgan.

Equities are taking a beating if there ever was one and in FX markets the caning of the USD continues even if there do seem to be slight signs of the Dollar Smile as the buck has reasserted itself against both the CAD and AUD (among others) lately. It is all very difficult to call at the moment and in the meantime the war drums are thundering about more skeletons rattling out of the closet as more financial institutions move nearer to the point where they are either bought up (bailed out) or find themselves having to close up shop. As an opaque veil over this whole situation the credibility of and faith in the Fed are being stretched to new lengths as the play-book increasingly falls short in terms of delivering a workable solution to the debacle. Moreover, the Fed is being criticised from many angles for what is perceived as "fiddling too much" with what was an inevitable rout in the first place and thus risking an exacerbation in the backdrop as an overly lax monetary stance fuels inflation. Note in passing that I am not being normative here. I think there is plenty of time for that later. However, whatever you think about the merits of the Fed's actions I am sure we can agree on one thing; if markets get to the conclusion that the Fed is out of control the mother of all self-fulfilling prophecies will ensue.

So, what happens next?

If only I knew. The first thing we need to dispense with is today's Fed meeting where traders and observers are now pencilling in a 100 basis point cut which would take the federal funds rate down to 2%. This would be a very aggressive move and as the Fed's armory gets steadily depleted one of the main yard sticks with which to assess such a measure would be the extent to which it restored some kind of calm to markets. I don't believe the Fed can (and should) hope to prevent financial institutions from faltering at this point and it seems pretty clear that a recession cannot be avoided either. In light of the uncertainty surrounding the effects of today's Fed decision I am however looking at a couple of themes that I believe will emerge in the weeks to come.

One thing which we have been discussing on and off here is the probability for a coordinated intervention to halt the buck's slide. Particular focus has been directed towards the BOJ as it had been presumed that once the USD/JPY moved below 100 the risk of the BOJ/MOF dipping their toes in the water would increase. As the JPY has appreciated to about 97-98 to the Dollar it has not so far prompted comments or action from Japanese authorities. Of course, we are only now going to discover what the new governor and leadership at the BOJ is made of, or are we? One thing is for sure, the charade which I (and others such as Takehiro Sato and Ken Worsley) predicted surrounding the BOJ nomination has now materialised. Muto, who was the original nominee from the leading LDP party was predictably given the proverbial thumbs down by the DPJ who control the upper house. The current governor's mandate expires in two days time and given the current market situation the last thing we need at the BOJ at the moment is a vacuum. Today, we seem to be moving into round two as the Prime Minister Fukuda presents a new nomination in the form of former Finance Ministry official Koji Tanami. The initial signs of relief do not look promising and in fact the DPJ seems quite keen on picking a fight on this one ... (quotes, IHT and Bloomberg)

``If the DPJ approves this nomination, they would let themselves fall into a political trap because they have argued monetary policy and fiscal policy must be separated,'' said Tomoko Fujii, head of Japan economics and strategy at Bank of America in Tokyo. ``An approval would make the DPJ look like they don't seriously care about the principal issue.''


A senior lawmaker in Japan's main opposition Democratic Party, Kenji Yamaoka, said there was almost no chance the party would accept Tanami as Bank of Japan governor. "Personally, I think it is almost impossible," Yamaoka said.


Japan's main opposition party said it will reject Prime Minister Yasuo Fukuda's second candidate to lead the central bank, assuring a vacancy before the current governor's term expires tomorrow.

What the situation at the BOJ will do to the potential for intervention is difficult to see. However, if the stalemate continues and a vacuum becomes a reality I think that intervention may well be the knee jerk reaction as well as of course a new general election seems immediately to be in the cards. More generally on the point of intervention we learned recently that both Goldman Sachs and Morgan Stanley are now officially in intervention watch mode and in this light Stephen Jen from Morgan Stanley moves in with some worthwhile observations. In his view the ground is not yet ripe as he puts it...

Our recommended tactical posture is to remain short the dollar for the time being, despite it being grossly undervalued against the majors. The preconditions for coordinated interventions are not yet met. However, given that a weakening dollar is fueling dangerous vicious circles through commodity prices and eroding confidence, it is prudent to remain on an intervention watch, monitoring closely whether the preconditions for interventions are met.

It is difficult to disagree with much in Jen's argument but I do think that there is a risk that events in Japan may unfold so as to make intervention come sooner rather than later. In Frankfurt of course the ECB is sticking to its one-page play-book on the back of the last meeting's turn in the discourse towards price stability as the main objective. Obviously the noose is tightening at the ECB. Despite some pockets of resistance from recent German data releases the European economic edifice is now visibly slowing and as an ever ominous shadow we have the situation in Eastern Europe where especially Hungary, the Baltics, and Romania are now set to grind to a halt. In this immediate light we could ask what in fact a 100 basis point slash by the Fed could do to the ECB's play-book? Or put differently, when will the ECB blink if at all? I still maintain my view that the course of events will force, or steer if you will, the ECB to cut rates in the first half of 2008 but I also concur that such a move won't be easily wringed and thus that the ECB is likely to postpone it as long as possible given the underlying inflation pressures.

Another theme I am watching is at what point the rest of the world will re-couple to events in the US. Intervention in the currency markets and/or cut in the interest rates by either Japan or Germany would obviously represent such re-coupling. However, the front line of all this is more likely to be one or more of the small emerging economies where recent excessive capital inflows, rampant inflation and now recessionary growth outlooks threaten to bring down the deck of cards. As my readers know I have been peering towards Eastern Europe for an example of this where Hungary in particular seem to be positioned as the main candidate not least on the back of the scrapping of the Forint's trading band. However, and by all means, Iceland is perhaps an even more apt candidate?

The Icelandic krona slumped against all 178 currencies monitored by Bloomberg today as the risk of its government and banks defaulting on debt soared to a record. The krona dropped to an all-time low against the euro and had the biggest one-day decline against the dollar in 15 years on signs credit-market losses are widening after JPMorgan Chase & Co. agreed yesterday to buy Bear Stearns Cos. Iceland's banks are ranked among the least safe in the world by traders of credit- default swaps, and the chance of Iceland defaulting on its sovereign debt climbed.

And don't for a minute believe that Iceland is a 'piqsqueak' by any means. You see, Icelandic investors have been very busy in recent years investing heavily in Scandianvian capital markets and financial institutions. There is thus, unlike the well known tectonic fault line cutting across Iceland in a vertical sense, a potential financial fault line which runs from Iceland to Scandinavia and on to Scandinavian banks' operations in Eastern Europe in terms of market correlation. This, at least, is a connection worth pondering I believe. More generally on the theme of de-coupling and re-coupling Stephen Jen also finds the time come up with some worthwhile observations ...

However, the macroeconomic data for much of the rest of the world (RoW) continue to surprise on the upside. In this note, we argue that, if the US does indeed fall into a recession, there will be repercussions for the RoW and their currencies. But this domino effect could follow four – not mutually exclusive – fall-lines. First, in times of broad risk aversion, we could see the currencies of current account (C/A) deficit countries weaken. Second, as the ‘Anglo cycle’ of debt and housing falters, the economies with financial systems and debt cycles similar to those of the US may suffer in turn. Third, if indeed the global economy is infected by the weakening US, commodity prices may put in a top, and commodity currencies may suffer. Fourth, perhaps the most obvious fall-line is how a slowing US economy could affect the RoW through trade.

I kind of like these four points since they allow us to make some subtle yet crucial distinctions between the linkages with which the US situation will spread. The most important thing to note here is that the current financial crisis in the US is not uniquely a US debacle. Note in particular in this context that what we are now seeing is how those countries with significant external deficits are the ones steadily moving into the front line of the incoming slowdown. This is an important point as it indicates the intimately coupled nature of the global economy. For each deficit there is a surplus and if we look at the surplus nations we see that domestic demand in these countries (e.g. Japan, Germany, China etc) is not at this point strong enough to maintain growth rates at the current level. This also highlights my main gripe with the whole de-coupling discussion in the sense that it should never have been a discussion of whether the USD should fall or not but against who it was going to fall! The current shift of liquidity in favor of the Euro, Yen and if you will the Swissie is not sustainable in this light. Rather we should be looking towards India, Brazil, Turkey, Thailand and of course China even if she does represent some sort of special case. Interestingly, this tendency is not hidden in the data. It is just that people do not seem to be paying much attention. Allow me then the luxury of quoting the final note from Morgan Stanley's GEF 17th March edition in which Marcelo Carvalho reports how Brazil is trying to pull a 'Thailand' as the authorities attempt the stop the inflows from coming in too quickly ...

The Brazilian authorities have this week announced measures to contain BRL appreciation. While such measures seek to temper near-term pressures for further BRL strengthening, we suspect that they will ultimately prove counterproductive, as fundamentals should prevail over time. The context. The local press has reported that the recent measures are aimed at containing BRL appreciation, supporting exporters and slowing the rapid deterioration in Brazil’s external accounts, as imports are currently growing much faster than exports. According to the reports, advisors to the president have warned him that the presidential elections in 2010 could take place amid a widening current account deficit, potentially reintroducing concerns about external vulnerabilities.

This my dear reader is the real process of de-coupling and unlike the one we are currently witnessing with the Euro and the JPY it will take time not least because the US economy itself need to finds its place in a new global economic edifice. As I noted in a recent piece on China what the world really needs is a slew of economies who are able to run a respectable deficit without running into excessive overheating like we have seen in Eastern Europe. I still believe the US economy is such an economy but it is not alone.

Ok, time to hold for now I think.

Markets are still in a rout as we move closer to today's Fed's interest rate decision and there are certainly an ample amount of potential risks to choose from out there. Some attention obviously needs to be directed towards the US and the Fed's desperate attempt to calm markets. I am already hearing rumours that Lehman Brothers may be the next to join the pillory. Meanwhile, I have also tried to look beyond the US where I noted how political conditions in the BOJ in Japan are deteriorating to such an extent that a risk is now emerging of unexpected actions and measures. What we need to realize is that the DPJ has now effectively chosen to pick a fight perhaps in an attempt to force a general election to flush out the highly unpopular Fukuda.

Another scenario which is popping up at the moment is for the LDP themselves to oust Fukuda but that would hardly solve much unless they were able to find a 're-uniting' figure, something I find rather doubtful. I also looked at the potential for coordinated intervention by the G7 in order to stem the tide on the USD. I agree with Jen that now is not yet the time but I also stress that Japan may be the source of some unexpected action.

One such action could be the lowering of Japanese interest rates to 0.25% or perhaps even the re-instatment of ZIRP. This would be tantamount to a process of re-coupling where the BOJ and ECB moved in to follow the Fed down. So far, this does not seem to be on the cards. As have been stressed endlessly here at GEM there is a short term and a long term trend here. On the former front I am expecting some kind of re-recoupling as the I simply don't see how the Euro and Yen can continue to appreciate against the USD to the extent that we are witnessing; the same goes for the Swissie here although, and in the same vein as with the Yen, carry trade unwinding seems to be the main driver here. On the latter account and thus in terms of the more structural nature of re-coupling I think that the world already has decoupled from the US. However, this will not be a process without hiccups. As I show with Brazil above and as we have seen with Thailand it won't be easy but we better start on it now since the current shift liquidity movements in favor the Eurozone and Japan cannot persist.


Was this the first time that the Fed did not give the market exactly what it wanted? It could appear so. Of course, few would be able to argue that this was not an aggressive move if there ever was one. Not only, did the Fed lower its main funds rate by 75 basis point to 2.25% it also lowered the discount rate, the cost of direct loans from the central bank, to 2.5 percent. Yet, markets were expecting 100 basis points and to my knowledge this is first time during these tumultous times that the Fed did not respond in kind to such expectations. Both Bloomberg and Reuters (as well as everybody else) have the story. Note in particular the slight bias towards acknowledging inflation. Could this be the last cut From Bernanke and co?

The Federal Reserve cut its main lending rate by three quarters of a percentage point to 2.25 percent as officials try to prop up the faltering economy and restore faith in the U.S. financial system. ``Today's policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity,'' the Federal Open Market Committee said in a statement after meeting today in Washington.

Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser voted against today's decision. Stocks pared gains after the decision, while Treasury notes remained lower. The dollar recouped part of its loss against the euro. ``Relative to where inflation is running is where you begin to get the real tension between addressing the liquidity problems in the banks and the capital markets, and trying to encourage inflation to be under control for the long run,'' former Fed governor Susan Bies said in an interview with Bloomberg Television. `They are running very close, in this very high inflation environment, to how much they can deal with.''