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US Treasury Nationalization of Fannie and Freddie finally halts USD charge

Mon, Sep 8 2008, 07:07 GMT
by John Hardy

Saxo Bank

All markets change recent direction on this move. How long will the reaction last? Volatility is the only short-term guarantee.

MAJOR HEADLINES – PREVIOUS SESSION

• New Zealand Aug. QV House Prices out at -4.5% YoY vs. -2.2% in Jul.

• Japan Aug. Eco Watchers Survey Current/Outlook out at 28.3/32.0 vs. 29.3/30.8 in Jul.

• Switzerland Aug. Unemployment Rate out at seasonally adjusted 2.5% as expected and vs. 2.5% in Jul.

THEMES TO WATCH – UPCOMING SESSION

Key Risk Events (All times in GMT)

• UK Aug. PPI Input/Output (0830)

• Canada Jul. Building Permits (1230)

• US Fed's Fisher to Speak (1700)

• US Jul. Consumer Credit (1900)

• UK Aug. BRC Retail Sales Monitor (2301)

• UK Aug. RICS House Price Balance (2301)

• Australia Aug. NAB Business Confidence (0130)

• Australia Jul. Retail Sales Trend (0130)

• Australia Jul. Home Loans and Investment Lending (0130)

Market Comments

The US government's dramatic announcement declaring the nationalization of the US GSE's Fannie Mae and Freddie Mac was the inevitable outcome of the enormous credit bubble inflated by easy Fed monetary policy in the wake of the tech stock bubble burst, lack of oversight in the credit markets by the government, and the related "financial innovation" that turned out to be the world's largest ever Ponzi scheme. This bailout is the ne plus ultra of the "Greenspan put" (enacted in the spirit of this put, even if it was neither Greenspan nor the Fed that engineered this takeover) and marks the end of an era in financial markets - an era starting in the Reagan years in which financial institutions were allowed to run amok and then had to be bailed out by the US taxpayer. This will be the largest and the last of such bailouts for some time. After the last two years' debacle, look for banks and brokers to operate in a completely different environment in coming years.

The announcement also marks the beginning of the end of the US housing catastrophe. While US home prices will continue to stay soft and could continue much lower in local markets, the largest chunk of the decline is likely behind us. After all, the government owned Fannie and Freddie will continue to lend money and institutions will now be somewhat happier to take on debt generated by these institutions knowing that the US government stands behind the guarantee rather than some feeble organization that could implode due to insufficient capital reserves. Of course, some may eventually ask if the US government itself is such an organization.

Now back down to earth and what this means for the markets right now: clearly, the knee-jerk reaction from this announcement is a sudden and massive increase in risk appetite driven by two factors: first, the market was getting very stretched and aggressive in positioning for further risk aversion, so the move we have seen simply represents a deleveraging of the hottest, short-term positioning in the market. This kind of reaction is very common on any big game-changing announcement and simply reflects a drive to neutralize risk while investors sort through the implications. Secondly, the assumption is that this step to nationalization will finally ease credit fears and risk willingness due to the market being able to worry less about systemic crisis scenarios. Credit spreads on mortgage-backed securities and other securities are likely to shrink and the easing of credit conditions will tend to favor riskier instruments and punish safe havens.

For the USD, we see a potential for three phases of reaction to this latest move.
- Short term: we see a sizeable rally in risk and sell-off in the USD due to market positioning risk and other factors mentioned above. Duration: 2 days to 2 weeks...
- Medium term: Medium term, we are likely to revert to a firmer USD again as the global economy works through the economic downturn and the market considers that the rest of the world still has potential to slow much further relative to the US, where the down cycle is already very mature.
- Longer term: longer term, this is a USD bearish story as the need by a country with an enormous current account deficit to pay for such a debacle exacerbates the balance of payments problem. Will foreigners be willing to soak up the hundreds of billions of USD of additional US treasuries that will be needed to pay for this mess?

Interestingly, we saw the beginnings of the current bounce in risk materializing already on Friday after the terrible US employment report pushed risk appetite to new lows. JPY crosses, for example, saw a massive pivot and closed the day on a very strong note.
Rumors were abounding about the Bank of Japan intervening, but it makes you wonder if significant players smelled what was coming before the announcement over the weekend. Regardless, the important fact on the fundamental side is that the US unemployment rate continues to spike higher and has worked up enough momentum that it is already a self-reinforcing contributor to the weak US economy. It will take several more quarters at least for the global economy to work through this downturn....

Published on  Mon, Sep 8 2008, 07:14 GMT