The headlines are all abuzz today with discussion of the soon to be announced “bad bank” package that would help lift the boulder off the chest of the banking system. The bad bank plan will be spearheaded by the FDIC and would potentially buy those toxic assets that are starving the banks of ability to loan money for fear of impairing capital. The plan might unfold next week, but its diffusion into the media this week has created a distinct air of euphoria. Stock indices are higher and currencies that have taken on the mantle of risk aversion are falling. Another head fake or will the dollar rebound and show its true colors?
In last week’s commentary we concluded that the challenge facing the Obama government might be compared to one of herding cats while that of the Europeans was to snap a lid on their own bucket of eels. And with this bad bank proposition the herding is underway. The Europeans still need deal with their own problems, which makes us skeptical of the euro rally that we are seeing hot on the heels of the news.
The traditional argument is that the American dollar and Japanese yen are safe haven stories. When equities sour and when the risk barometer shouts out loud, investors repatriate funds, close losing carry-trades and don their tin helmets by holding a currency even if it is completely stripped bare of its yield. While the challenge for the bad bank is to castrate the toxic debt from the nation’s banking system the question remains whether this will be enough to restore the economy to its former glory. We believe, like many people, that there is no quick fix here and that the road to recovery will still be marked by some sincere soul-searching as to whether the glory days are really what society needs. One CNBC anchor noted this morning from Davos that “we can’t live without leverage,” in an appeal for resolution. We’re not sure that the ultimate goal here is to provide the banking sector with a stable platform to lend individuals several times their income to buy a house. Regulation will undoubtedly result in restraint on what individuals could and should borrow as a result of the last decade of profligacy.
In another knee-jerk show of optimism the commodity dollars are higher as a result of the bad bank story. It’s as if the whole world is reliant on America to mend its problem so that we can all get back on track. Remember, without an American-inspired solution the global economy will remain mired in recession. With one the American economy will ultimately show, but that doesn’t provide a get-out-of-jail-free card for other economies.
The Eurozone especially will face a survivorship crisis as a result of the fiscal demands and finger-wagging it will create between states already busting at their fiscal seams and those that lose control. It’s hard to see the attraction of the euro at this point and feel the need to look ahead beyond the news announcement of the bad bank to what lead it should inspire in Europe.
Those Aussie and Canadian dollars are making hay because the bad bank should help boost global demand. Over the past week, put open interest on the Canadian dollar declined by about 1,500 contracts as investors retracted their bearish claws a little but they added practically no calls. Aussie dollar option open interest was also unchanged.
The biggest change to open interest comes from the exodus of investors from bearish puts on the euro, where they quit their bet that the single currency would tumble as far as $1.2050 by March. Some 13,226 puts were sold to close positions, which reduced open interest.
Overall open interest on the British pound rose as its story becomes vogue. Speaking in Davos,
George Soros admitted he’d stopped selling the pound before it fell against the dollar to beneath $1.40. The earlier announcement from Barclays Bank that it had capital well in excess of what regulators require also created a reversal of negative sentiment. Recently the pound slid to $1.3503 and the declining fears surrounding a government bailout of another behemoth has stopped the rut. That’s another sign that investors are reacting to news in a piecemeal fashion and not really sticking to the agenda.
For now, the colors of the greenback are starting to run. There is a lack of bad news to hurt other currencies in the short run, which works its way through to an apparent run on risk aversion trades and rears its head in lower implied volatility. Currency implied volatility is marginally lower than it was one week ago. Euro volatility is back to 20.4% while that on the British pound is lower at 22.7% from 24%. Aussie volatility is back beneath a reading of 30% and stands at 28.5%.
The world will look a very different place when we are finally able to look over our shoulders at the many steps to recovery. We still think it’s way too soon to discount the success of the bad bank story and to revert to dollar-bashing simply on account of a ballooning budget deficit. That deficit after all is what the price of recovery.
