EUR/USD Weekly Outlook 9/7 thru 9/12 2008 part 1

The summer session is officially over and all market players should be back at their desks and ready to go. Unfortunately this does not guarantee market conditions will stabilize and return to order.

We’re entering our ninth week of an ill-liquid and dysfunctional market. The prior eight weeks have given us historic moves never before seen by the markets. At this point I do not see any reason why the chaos will stop now.

A couple weeks ago we talked about the potential of a big event or several big events going down sometime after Labor Day. As I’m sure you’re aware, the big story today is the Treasury’s plan to rescue Freddie and Fannie. It’s now official that the government has taken over Freddie and Fannie.

This bailout of Freddie and Fannie will be called “temporary” and will be spun as a brilliant move by the Fed and Treasury to divert financial disaster… you can tell your daughters fairytale’s really do come true because this move is one of the biggest fairytale’s I’ve ever heard in my life and now it’s a reality.

Here’s a 30-second overview of what Freddie and Fannie are. They are entities basically partially owned by the U.S. government. They are the holders of 50% or more of all home loans originated in the United States. Freddie and Fannie buy home loans from banks and banks use the cash generated from these debt sales to loan money to other investors to continue the process of credit expansion.

Freddie and Fannie raise cash by bundling up home loans and creating bonds and then selling bonds to financial institutions in addition to being publicly traded. So, we have Freddie and Fannie buying mortgages that have gone into foreclosure which means the bonds they’ve sold financial institutions are not worth the paper they’re printed on. I think you can see the issues here…

Here’s the scary part you probably won’t hear on the mainstream news… the fact that the Treasury took over control of Freddie and Fannie means that the government has an almost unlimited debt ceiling. The only other option would have been to pump equity into the two companies but that would have put limits on how much taxpayer cash could have been utilized. Now with this plan it means the Treasury can pump in the cash equivalent of the national debt – trillions of dollars. Think about that for a moment…

Freddie and Fannie equity holders will suffer. Dividends will no longer be paid and it’s likely their stock will be zeroed out and this very well could send shockwaves on Wall St. and on the global markets.

The big question is how this bailout move will affect the EUR/USD. There are a few possibilities. It would be great to be able to clearly see the exact answer. Market conditions have been so disorderly the past few weeks I can’t rely on expecting things to play out as they should but to expect them to defy logic.

The dollar has been on a historic and unprecedented rise across the board on all currency pairs. The dollar is climbing up the USD Index chart like some crappy pop band on the Billboard Hot 100 list. One possibility is that the Treasury’s bailout of Freddie and Fannie will only further strengthen the dollar because it will show the markets that the Fed and Treasury aren’t going to let any mega financial and credit institutions fail.

The markets will be lured into a false sense of security and will trick themselves into thinking they have Bernanke and Paulson’s shoulders to cry on. The euphoria created by Paulson handing Freddie and Fannie a checked signed by the U.S. taxpayers and then hyped up by CNBC and Bloomberg could easily add new value to the dollar.

In February when the Fed stepped in with JP Morgan to bail out Bear Stearns the dollar took a nasty hit. At that time though the fundamental landscape of the market was different and the euro was at the start of another strong bull run against the dollar. Fed and ECB monetary policy were different at that time as well. The Fed was still in a rate cut cycle and the ECB was still in a rate hike cycle. Those conditions don’t exist anymore.

Logic tells me that a government bailout of a financial institution should be terrible for the dollar. It should cause a strong move against the dollar. Let me be clear – if the markets respond the proper way to this move, the USD will take a hit. But, as market conditions are now I cannot rely on the market to respond the way it is supposed to, so once again I’m expecting the worst and will be thrilled to see the best.

Another reason this bailout may strengthen the dollar is because in one respect it could be viewed as another event contributing to the sharp deflationary season the markets and central banks have miraculously found themselves in the past two months.

The billions of USD that were lost in the winter and spring have helped contributed to the dollar’s surge and instantaneous appreciation this summer. There’s a vicious appetite for dollars, as you very well know. This vicious demand for dollars as it relates to the diminished supply of dollars has helped fuel this historic appreciation of the dollar.

If Freddie and Fannie’s equity gets zeroed out, this will cause a chain reaction of losses. Hedge funds, global financial institutions, and even central banks that are holding paper from Freddie and or Fannie will take a massive hit. This round of USD losses could easily add more fuel to the supply/demand situation we have the USD.

EUR/USD price action from the prior seven weeks supports this possibility because there’s literally been no demand at all for euros. Nobody is buying euros. And when I say nobody, I mean nobody of market-moving significance. The EUR/USD price action tells it best.

Last week several of what I call “B-list” central banks like Brazil, Indonesia, India, Taiwan and a few others intervened in the open market to halt their respective currencies from their massive depreciation against the dollar. These B-list central banks are fighting a losing battle because of the global demand for dollars right now.

There is no solid fundamental basis for the rise of the dollar. The fall of the EUR/USD has certainly been hastened by the Eurozone’s weakening fundamental situation but the bulk of the blame cannot be put on Europe. Now, it certainly doesn’t make matters any better when top ECB central bankers hate on their on currency and call the euro “overvalued”.

Why would the ECB want to see the euro depreciate? There are a few good reasons… the depreciating euro contributes to declining commodity prices which contributes to price stability, it bolsters exports, it relieves political tensions and quiets outspoken critics of the ECB’s tight monetary policy, it gives Trichet more flexibility to keep rates at 4.25%, and it levels the playing field on a global basis. It just relieves a lot of headaches that were caused by the strong euro and the USD Index moving towards a sustained break of the 70 level.

This is all well and good but the rapidly appreciating dollar is going to create a new round of negative affects on the U.S. economy if it’s allowed to persist. While the dollar was worthless the U.S. economy benefited by selling more big ticket items which helped support GDP and overall growth conditions.

U.S. exports are going to take a hit which means the already abysmal Trade Balance and Current Account will take a hit, and all three of those factors are very USD-. Add to the fact that global economies are strangled with high inflation, slow growth, and recessionary characteristics. This means global demand for U.S. exports will slow because global need can’t keep pace with supply.

Can you see why these are such complicated and confusing times were in? The Fed and ECB will be thrilled to see crude break $100. But with supply and demand issues pushing crude down, this pushes the dollar up. The question is how comfortable can the Fed get with the strengthening dollar? What is the Fed’s tolerance? I can’t answer that question but at some point the rapid dollar rise is going to further complicate near-term monetary policy.

I could sit here and write a novel making a case against the dollar’s rapid rise and making against why it should stop. I could also make a case for the rapid decline of the euro and why it will persist in the near term but I don’t see the point in doing that.

For me I’m just taking one day at a time. I’m not even trying to make sense of everything but rather just to keep pace with what’s happening on a daily basis.

CONTINUE