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FX Briefing

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Financial market crisis claims more victims

Mon, Sep 22 2008, 12:12 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlights

• Hank and Ben plan emergency operation

Wall Street in state of emergency

The financial crisis has reached a new dimension this week: Lehman Brothers Holding had to file a petition under chapter 11 of the US Bankruptcy Code; the collapse of the US insurer AIG was only averted by the Fed agreeing an $85bn bailout and the US government taking control of the company. The Bank of America has taken over Merrill Lynch, and Lloyds TSB has bought the British mortgage lender HBOS in a governmentbrokered deal; Morgan Stanley urgently started looking for a merger partner with a strong capital base and is in talks with Wachovia and China’s CIC. The central banks of the large industrialised countries are once again pumping huge amounts of liquidity, mainly US dollars, into the money market, to ease the enormous tension. According to news reports, in the last fortnight, US investors have withdrawn the record sum of $89bn from money market funds. Equity markets have plummeted to new record lows, and credit default swap spreads for financials have exploded.

Towards the end of the week, the US government pulled the emergency brake: Treasury Secretary Hank Paulson announced that Congress together with the Federal Reserve was working on a plan to set up a special vehicle to buy up toxic assets (i.e. illiquid mortgage-backed assets) from financial institutions. The aim is to unburden bank balance sheets and reduce valuation uncertainty – crucial to restoring confidence in the financial sector. Details of the plan have still to be worked out, but it is already clear that the US government, which has already forked out billions for Fannie, Freddie, AIG and Bear Stearns, will burden itself and tax payers with even more enormousenormous risks. Supposedly, this special vehicle is to be allotted $800bn. A further $400bn are to be put into the government’s deposit guarantee fund.

The forex markets’ reaction to the unprecedented deepening of the crisis was remarkably restrained. During the course of the week, EURUSD rose to 1.45 for a short time. The dollar lost slightly more ground against the yen and the Swiss franc: USD-JPY fell below 104 temporarily and USD-CHF below 1.10. Cable rose to almost 1.83. However, on Friday, after the rescue plan had been announced, the dollar recouped most of its losses. Towards the end of the week, the euro was around 1.42, USD-JPY 107.50, USD-CHF about 1.12 and GBP-USD just under 1.80. Compared to the previous week, the dollar’s losses were small, especially bearing in mind that in the last few weeks, a lot of confidence had been placed in the US currency.

Perhaps the most important argument in favour of the dollar at present is the fact that the US government has taken the initiative and is trying to find solutions to the problems. The new plan is further proof of this. In comparison, European policy appears passive. Although the problems in the financial sector are likely to get even worse due to the economic downswing in Europe, policymakers are offering little more than reassuring words.

Although the US government’s initiative has calmed things down a bit, the financial crisis will continue to dominate events in the markets next week. Markets will be keenly awaiting details of the plan, as well as the speeches of Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke in the Senate on Tuesday and Ben Bernanke’s statement before the Joint Economic Committee of the Congress on Wednesday.

In this environment, fundamental data are only likely to have a limited impact on the market. There are some important indicators on the agenda, however, particularly in Europe: towards the middle of the week, several national sentiment indicators in the eurozone countries will be published, including the ifo business climate index on Wednesday. We are expecting these to have deteriorated further on the whole. Towards the end of the week, the preliminary September German consumer prices will be released; the inflation rate will probably fall below 3%. Thus the fundamental data are showing that the ECB’s scope for cutting interest rates is increasing.

It is not clear, however, what impact this will have on the dollar: it could benefit from the “bonus for political initiative”, and possibly from the signs of economic weakness in the eurozone. The situation in the US financial sector in particular continues to be extremely uncertain, however.

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Published on  Mon, Sep 22 2008, 12:42 GMT