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The Dollar Rescue

Tue, Sep 30 2008, 10:18 GMT
by Joseph Trevisani

FX Solutions

The success of the Federal Government's rescue of the US financial system may not be known conclusively for several weeks or even months. But the currency market reaction is already charted. From mid-July until mid-September the dollar gained almost 13.5% against the euro. In the past two weeks, as Lehman filed for bankruptcy, AIG sold itself to the government and Merrill Lynch fled to Bank of America, the dollar gave back half of that gain.

Has this latest phase of the financial crisis forced a fundamental revision in traders' view of the US dollar? Or did the news hit a currency market ripe for a profit taking reversal after the dollar's recent record setting climb. Were the events of the past week a trigger or an earthquake or both?

The financial contagion that originated in the US housing market is a worldwide phenomenon. It has infected equity and financial markets around the globe. Russian, European, Asian and British equities have suffered substantial losses. Credit markets in Europe have experienced widening of spread premiums for securities other than the safest grade as in the US credits markets. For a time last week US Treasury notes were sold with zero interest so great was the pressure in panicked capital markets for preservation.

Debt from the US markets and particularly from the government sponsored enterprises Fannie Mae and Freddie Mac was packaged and sold to institutions in every global financial center. The Washington Government had no choice but to make their implicit guarantee explicit. But financial problems were hardly limited to US institutions.

In Europe Fortis, Belgium's largest financial services firm, received a 11.2 billion euro infusion from the governments of Belgium, the Netherlands and Luxembourg in return for equity stakes in the company. The shares of Fortis fell 20% in two days trading last week. Its price is off 71% over the past year. Officials are reportedly seeking a buyer for all or part of the company and have not ruled out nationalization as a last resort.

In Britain, Bradford and Bingley the nation's largest lender to landlords was seized by the UK Treasury to protect depositors. Its shares have fallen 93% this year. This would be Britain's third major bank forced to end its independent existence. In February Gordon Brown's government nationalized Northern Rock Plc, and HBOS Plc sold itself to Lloyds on September 18th.

In France the share price of Natixis, the fourth largest French bank, fell 20% in Monday trading. It has lost 76% of its value over the past year.

After much drama and election year politicking the US Congress is expected to pass the financial rescue measure this week. It is a bill largely unchanged in its effective provisions from the one proposed by Treasury Secretary Paulson a week ago. Congress will pass the bill because it dare not do anything else lest it risk blame for the ensuing recession. It will provoke voter wrath (the American public is against the rescue) even as it attempts to absolve itself from its very large guilt in creating the sub prime debacle and refusing to perform its legal oversight of Fannie Mae and Freddie Mac.

As this crisis is one of bank confidence, the Federal rescue with its real relief for bank balance sheets, should succeed in restoring over time a functioning US market, if not in returning unbounded confidence. Banks will lend to each other and the normal round of electronic credit will gradually resume.

The US financial rescue will also calm the world's financial markets and rescue the dollar, at least for the time being. The collapse of the American investment bank sector will prove to have been a trigger for profit taking rather than a fundamental rethink of the European and American relationship. The currency markets will return to the comparison of the economic situations of Europe and the United States, with the advantage still likely to fall with the US, though that will require statistical proof.

The Fed has proved staunch this time by not cutting rates to deal with a liquidity and confidence crisis. If the rescue succeeds in alleviating the financial panic and restoring a portion of normal credit practice, Mr. Bernanke may not be tempted to cut rates again. For the European Central Bank (ECB) governors the story is the opposite. Inflation is retreating. The money supply, unmentioned by the ECB recently, is now at 8.8%, not far from the official target of 8.0%. Despite their rhetoric the ECB governors will be sorely tempted to cut rates soon. The dollar could benefit on both the economic and interest rate fronts.

But in the longer analysis the addition at one stroke of so much potential debt to the Federal balance sheet could well give pause to foreign investors. These are the investors the US government needs to fund its deficit.

The unthinkable has happened to America's financial institutions. In the space of a little over half a year every independent investment bank has disappeared. The financial markets have just been treated to the terrors of a collapse of credit confidence.

The US Government is addicted to deficit financing. This is not a scheme that can go on forever. One can justifiably ask, what else except historic confidence supports the belief that the US government can continue its profligate ways? If investors begin to consider the unthinkable for US debt, then no amount of US economic growth will suffice to support the US Dollar. If the world's investors begin to reconsider US credit, this current crisis will have been like the earthquake that produces a tsunami five thousand miles away.

Published on  Tue, Sep 30 2008, 10:21 GMT