EUR/USD Weekly Outlook 10/5 thru 10/10 2008

Financial booms and financial busts are nothing new to United States. The financial crisis of 2008 in many ways is just a repeat performance of the first great economic depression that started in 1837 and did not end until 1843.

By the early-1830’s the US was in a height of economic superiority. Foreign capital, especially from Great Britain was pouring into the US. Commodity prices were at staggeringly high levels. Hard currency (gold and silver) was being “avoided” by banks. The money supply rose 200% during that time. The US government was issuing debt and foreign money flows helped vast infrastructure expansion throughout the States.

At the very center of this financial boom was – real estate. It wasn’t referred to as real estate in those days, it was known as land speculation and the investment banks were the financiers of this land speculation which contributed to an overall time of strong economic growth, a manufacturing boom, a strong bull market for commodities, small business growth, and western expansion.

The whole boom was backed by easy credit and floated on debt. The appetite for gain was fed by the banks as they gave loans to just about anybody with a heartbeat. High leverage, quick access to credit and loose lending standards was the common theme of the day. In a short period of time land values skyrocketed and prices rose accordingly.

By 1835 the dance was about to be up. The US Trade Balance was in terrible shape as imports greatly exceeded exports. In the summer 1837 the entire house of cards came crashing down as commodity prices depreciated with fury. The speculative land market crashed. There was a major crop failure. Foreign money flows dried up.

The panic began when President Andrew Jackson issued an order that basically called for a return to hard currency. As the panic set in foreign banks and investors demanded immediate payment. US banks refused to make payment and as you can imagine a series of financial failures… bank failures, land foreclosures, and defaults on debt repayments.

In 1837 Andrew Jackson plundered the central bank and redistributed the banks funds to smaller regional banks. Meanwhile the US financial system was collapsing and it was spreading to foreign investors who made high risk loans and investments in the US.

Unemployment hit 10%. Poverty hit record levels in the US for that time. New York City was hardest hit and the depression caused by the panic of 1837 wiped out over half of those employed in the NYC financial sector. Ultimately the roots of the Civil War can be traced backed to what happened during this period of time that started with the Great Panic of 1837.

That’s the “Readers Digest” version of what happened, but what we learn from history is this first great depression in American history was rooted in cheap credit, debt, real estate, and politics. Sound familiar? Do we find any similarities between the depression started in 1837 and the recession started in 2008? I think it’s hard not to see the correlations.

I will not go as far as to call our current situation a depression but it’s certainly a recession and can certainly get much worse than what we are experiencing now. We need to keep a few issues in perspective… during the Panic of 1837 and the Great Depression of 1929, how many citizens had the type of access to credit as they had between 1998 and 2008? The other issue is what role did housing play during those two financial disasters?

Consumers did have credit during both of those historical depressions but it was not nearly to the degree as in the late 20th-centruy and early 21st-century. The average US consumer that uses credit lines holds nine or more credit cards – there were no such things as credit cards and home equity loans in those days. In our modern financial landscape we have an economy driven by the consumer, by debt and credit, and by the ability to use assets to obtain more credit and leverage.

This landscape did not exist during the Great Panic and Great Depression and I believe those issues further complicate the current financial crisis that has fully engulfed the US economy and world economies. In other words, history is being repeated and history is about to be made.

All the time I hear talking heads saying how great it is to have Bernanke leading during this crisis because he was a student of the Great Depression. I fail to see the benefit of this because if Bernanke was truly a student of the Great Depression his policies would not continue to intensify the very issues he’s been appointed to fix.

It was easy credit and loose monetary policy which contributed to the housing and commodity boom. Based on my study of the bailout bill I see that the Fed and Treasury have a plan to inject liquidity into the money markets, creating more debt, and taking on risk by purchasing assets that cannot be priced by the free market and have no determinable market value.

I won’t deny the credit markets have been tight and money has been more “expensive”. The dollar’s “strength” is just a byproduct of a market that is hoarding cash and needing the USD. Supply and demand issues coupled with high USD interest rates on the money markets create the perfect storm for the dollar to stay relentless against some of the majors.

So the Treasury is going to unfreeze the credit markets by injecting billions of dollars of cheap money at low rates… and this ultimately solves the problem how? I really do not see how this solves major issues of an inflated money supply, a dismal trade balance and current account, and a plunging jobs market.

The past 12-weeks have been a time of massive and dramatic deflation. Between the investment banks deleveraging, crude, gold, and the euro giving up all their 2008 gains… they were all booms that went bust. Just about all asset classes that made historically high gains the past two years have deflated. The biggest boom that went bust has been the housing market.

The Fed and Treasury have now used politics to achieve what basically looks like a plan to add some boom back to that busted market. Some of the methods are what caused some of those other asset classes that are now bust to potentially go boom one more time. The market will ultimately decide and only time will tell how this all plays out.

If this season of hyper deflation comes to a halt and inflation returns to the global economies you can be sure equities will make a strong recovery. If the Fed, BOJ, ECB, and BOE want to re-inflate their equities markets it will take inflation to do so. The S&P 500, Dow, Nikkei, and the European bourses will not truly begin to recover until the deflation stops and the inflation kicks up again.

The trillion+ worth of liquidity that has been and will be pumped into the markets should eventually weigh on inflation and within a year or so inflation levels should be moving back up noticeably. Right know it is very likely we’ll see CPI data come in slightly better than expected in the near-term which will give the central banks justification to maintain loose monetary policy. The market will keep begging the central banks to liquefy them as long as the central banks continue to show a pattern of being at their beck and call.

I do not believe we have seen the worst of the worst yet. I have little faith in this bailout to really accomplish much and I believe retailers will suffer this Christmas and the housing market will continue to weaken throughout the rest of the year. Credit has dried up for the American consumer and for many Americans this will mean a total lifestyle adjustment. I see this being a painful process for the economy to go through but one that is necessary. The re-pricing process of markets must not be manipulated or else the next boom will come faster than the last and the bust that follows it will be more painful.

Fed and ECB:

There is strong talk going around the markets about a Fed cut of 50bps and an ECB cut of 25bps happening at any moment. Like a coordinated rate cut type thing. Fed Funds futures are showing a 100% probability of another 50bps cut before the end of the year. The banks are calling for an ECB cut in November.

So what would the EUR/USD do if the Fed and ECB both cut rates at the same time this week? Nobody can say because it’s never been done before. It would be a completely unique event unlike the markets has ever seen. My best educated guesstimate would be that the dollar would likely benefit because it would be more of a shocking move on the ECB’s part and it would send the markets into a panic that the ECB has taken their focus off of their number one mandate of price stability and they are cutting rates to fight the European recession and stimulate growth.

I won’t say a surprise rate cut can’t happen as early as this afternoon or at any point this week. Nothing will shock me any more. A move by the Fed or ECB would not surprise me at all whatsoever and I’m ready to do some nasty battle with the market should we get a crazy move on interest rates. All traders should be ready just in case this scenario plays out. I don’t see how a Fed rate cut would benefit anything but this is Bernanke we’re talking about…

Fundamentals:

The fundamentals this week will be more about the Fed and ECB. Bernanke is speaking and Trichet will be speaking several times this week. Other members of the Fed and ECB are speaking throughout the week and this means the central banks will be using their opportunities to manipulate the markets and to sell whatever ideas they are trying to get the markets to buy this week.

As far as fundamental data is concerned, we do get key housing, production, and growth data. We have Pending Home Sales, Trade Balance, Initial Claims, and Crude Inventories. Out of Europe we German Factory Orders and German Industrial Production.

If this week’s housing data is bad that will cast doubt on whether the Treasury can turn a profit on the mortgage debt they are purchasing. If credit is truly as seized up as Paulson and Bernanke are saying, this should correlate into USD- homes data. The weak jobs market would also be a contributing factor to a downside print on the data.

In my opinion this week’s fundamentals are all about the Fed and ECB and what they have to say to the markets. The fundamental events we need to be most concerned about is a surprise rate cut, a bank failure, or some sort of financial rescue plan out of Europe. I don’t expect great data out of the US or Europe this week and the battle of the worsts will continue to rage on…

EUR/USD:

At this early point in the week buying the euro is not a part of my trade plan. That being said, I’m open to the idea of buying the euro and I believe the euro may actually have a fighting chance if the following factors begin to work in favor of the euro and against the dollar:

LIBOR: dollar interest rates have to drop, plain and simple. If the overnight USD lending rates on LIBOR continue to stay elevated and exceed the Fed Funds Target Rate and ECB Key Lending Rate, this shows there is strong demand for USD and this demand will translate into USD strength no matter how bad the USD data is or what commodities are doing.

USD Demand: this is tied into LIBOR as well. If the strong appetite and demand for dollars subsides this week and there is a renewed demand for euros, this would help the EUR/USD gain some traction to move up.

Commodities: it will be imperative for crude and gold to find support and find buyers in order to put some sort of roadblock in front of the dollar to slow it down. I’m not too worried about gold because a case to buy gold can be made. Crude worries me. I don’t see any reason why we cannot test the $88 level this week if crude stays on this course. Another leg down on crude and the crude may take another leg down with it.

Rate Cut: if the Fed did a surprise rate cut of 25bps or more and the ECB held rates steady at 4.25% we should see money flows go back into the euro and out of the dollar just based on Europe offering an ever more attractive rate of return. Now if the ECB does a surprise cut I would expect a test of the 1.3200 level this week.

Wall St.: this will be our first test of how Wall St. and the global markets respond to the reality of our new bailout package. Trying to predict how these markets will respond would fry too many brain cells that I can’t afford to lose right now. I am hoping the markets realize what a massive amount of debt will be created the next year and remember how many dollars have been flooding the market and decide to respond accordingly.

Europe: Over the weekend the leaders of the top four European economies along with Trichet and the EU Commission met to discuss the financial turmoil in Europe and to begin working towards a coordinated plan to intervene. I’m trying to figure out how they could actually do a joint effort because their entire financial, economic, and banking system runs differently than the US system. Europe doesn’t have a “Treasury” and they don’t have a Hank Paulson, thank God. Based on the ECB mandate and Maastricht Treaty, I cannot see how there is a possibility to bailout the European banking system.

The UK is clearly in trouble. Gordon Brown seemed a little stressed at the weekend meeting. I don’t follow UK politics much so maybe he’s always that way, but he was extremely vocal about putting together a plan to not let a single bank fail in Eurozone and that included the UK. I could be wrong but I have a feeling Mr. Brown is not too thrilled about Ireland’s plan to backstop Irish banks with deposit and bond guarantees. If I lived in Europe right now you better believe my money would be pulled from my bank and I’d have a new bank account set up with an Irish bank.

If the rest of the European countries follow Ireland’s lead we could see some renewed faith in the European banking system. I don’t see how they can avoid doing what Ireland did. If they don’t I would think most Europeans would start opening bank accounts in Ireland to get that guarantee.

How good is an Irish guarantee? I have no idea. I can’t speculate on that but the problem with this guarantee is that it could cause a liquidity issue with the EUR. And what if the Irish are pressured by their old adversaries in Great Britain to repeal the guarantee and they take it back? That means there would be a run on Irish banks and that could start a chain reaction of European bank runs and that would destroy the euro. This stuff just doesn’t get any easier does it?

As far as trading goes my plan is to continue shorting the euro on the rises and I will not take risk on buying the euro unless I see some of those factors from above begin working in favor of the euro and against the dollar. The euro will have a fighting chance if calm returns to Europe and the markets go from panic mode to more of a normal mindset. The optimist in me believes at some point the markets will realize what terrible financial and economic shape the US is in and how terrible the fundamentals and the bailouts are for the dollar and they will respond accordingly against the dollar.

I’m going into this week expecting to see the same kind of volatility and chaos we’ve seen the past four weeks and I will be pleasantly surprised to see normal price action should the markets decide to calm themselves down and start behaving like adults. I don’t see anything that says order should return this week, so I’ll expect the worst and be happy with the best.