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FX Briefing

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US government places Fannie Mae and Freddie Mac under conservatorship

Mon, Sep 15 2008, 06:53 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlights

• USD profits from deleveraging and repatriation

Dollar defies bad news from the USA

The US dollar was able to consolidate its position against almost all of the important currencies this week. EUR/USD hit a twelve-month low and temporarily slid to 1.3888, although most of the news was unfavourable for the USA: weak labour market data, Fannie Mae and Freddie Mac nationalised, limitation of oil production quotas, crisis at important US investment bank. However, this news did not adversely affect the friendly trend in the US dollar. It was not until Friday that EUR-USD corrected to just under 1.41 – still more than one cent below last Friday’s level.

Ever since commodities prices went into reverse in mid-July, the dollar has appreciated against all the other main currencies – in particular against the Australian and New Zealand dollar, the Swedish krona and the Norwegian krone, sterling and the euro. Least affected of all was the Japanese yen, which benefited from rising risk awareness that prompted investors to unwind their carry trades.

The strength of the US currency is mainly due to the fact that economic weakness has meanwhile spread from the US to the global economy. In its interim forecast, the EU Commission emphasises the risk of a technical recession for Germany and the EMU, for example. However, the appreciation of the dollar is not indicating brighter prospects for the US economy – this was impressively confirmed by the US labour market data for August. The sharp rise in the unemployment rate from 5.7% to 6.1% was particularly shocking; the rate is now more than 1.7 percentage points up on the cyclical low of March 2007.

This is dampening the prospects for private consumption, the most important demand component in the USA. Real consumption is expected to have fallen in the current quarter already, the first decline since the fourth quarter of 1991.

In view of the drop in oil prices by almost 30 % since mid-July, OPEC has cut its production quotas by 520,000 barrels per day as it considers the international oil market to be “oversupplied”. Although this step did not come out of the blue, many market participants had not expected the cut to materialise before December. The OPEC decision stalled the oil price decline only briefly, the WTI having fallen to just under USD 102 per barrel since then. Accordingly, the decision only had a short-lived impact on the dollar, too.

Although the announcement that the two mortgage finance companies Fannie Mae und Freddie Mac would be placed under conservatorship was certainly bad news, it was nevertheless welcomed by the equity markets, as the government intervention secures the repayment of debt and guaranteed loans which in turn reduces systemic risks. According to William Poole from the Federal Reserve Bank in St. Louis, the burden on the US budget could amount to as much as $300bn.
For the time being, however, this appeared to be the lesser evil for the global markets.

The crisis on the financial markets was back in the headlines again when it emerged that the capital increase by the investment bank Lehman Brothers might fail. Lehman Brothers furthermore reported that its quarterly loss had risen to $4bn in Q3. The uncertainty regarding the bank’s future dampened the US dollar only temporarily.
The dollar actually appreciated afterwards, because more than anything else this case illustrates the fragile state of the global financial sector. But on Friday, the relief after the announcement of a possible buyer finally put some pressure on the dollar.

Although the financial crisis had its origins in the United States, it is now even supporting the US dollar. Investors around the world are reducing risk positions in the commodities, fixed-income and equity markets they had financed with loans taken out in low-interest-rate currencies. Thanks to the Fed’s massive interest rate cuts, the US dollar is benefiting from this deleveraging, not unlike the traditional carry-trade currencies, the Japanese yen and the Swiss franc. What is more, substantial volumes of US capital invested abroad are now being repatriated because the slowdown in growth is affecting more and more countries, including the emerging markets.

A meeting of the Fed’s Open Market Committee (FOMC) is scheduled for next week. Its risk as uncertainty regarding inflationary trends remains a concern, but the decline in energy prices and unit labour costs in the second quarter bolster the expectation held by committee members that inflation rates are set to become more moderate in the near future. As for growth, the FOMC will probably emphasise that – despite strong secondquarter growth – risks remain high, all the more so as the credit crunch has intensified and unemployment has risen sharply.

The Fed is therefore very unlikely to reduce its monetary stimulation any time soon. In any case, the markets have already sharply scaled back their expectations that US interest rates would turn around shortly, so that a statement worded along these lines need not weaken the dollar.
However, given the strong appreciation of the US currency, a potential temporary setback cannot be ruled out.

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Published on  Mon, Sep 15 2008, 11:08 GMT