All's Well that Ends Well?

So goes the title of one of Shakespeare's plays, and as I am slowly adjusting to life in Lausanne and its beautiful environnements I am forced to admit the truthfulness of this axiom. Consequently, and while I have now settled down in a nice shared apartment I feel the need to confess my readers the tremendous difficulty with which I, finally, managed to secure housing in Lausanne. I will not belabor you with details, but merely pass on my humble advice that if you are ever going to Lausanne (indeed, the entire Vaud canton!) looking for short term rental accommodations ... bring valiums or deep pockets, and preferably both!

In any case that is now well past me and to prove that I am now safely and nicely housed I have chosen to flatter this entry with a picture, taken from my room, showing the view of the lake.

The only, and quite annoying, thing I am missing is internet at home. That should be sorted this week, but until then, I am living life like a nomad trafficking from one hot spot to another.

However, and although I have managed to emerge unscathed from occasional thoughts of throwing in the towel and returning to the solace of my Northern home, it is still too early to say whether the story written on the financial and economic year 2008 will also adhere to the adage provided by Shakespeare. Consequently and looking forward to the le fin de l'année 2008 as well as the most recent waves of market activity, I would note the following in terms of what I have been, and will be, looking at.

Paulson Fires the Bazooka

First of all it is of course impossible not to briefly note the nationalization of US mortgage giants Fannie and Freddie Mae. The fact that it is now reality is not in itself surprising. As I have argued before, I think the script of the unfolding drama was written already back when the shares of FRE and FAN plummeted and foreign holders of agencies all chimed the same choir of relative irrelevance as they considered their papers backed by the US government. When congress later shipped off the now fired Bazooka to Paulson's office it was only a question of time before a proposal was put on the table. I will leave it to more informed minds to nit pick the actual deal, but merely note that it seems that common and preferred stock holders will see nothing but the vapor of what was once portfolios of Freddie and Fannie stocks.

From a slightly more wonkish perspective I would also like to reiterate the point conveyed by David Reilly and Peter Eavis on preferred stockholders in their small WSJ piece (hat tip: Felix Salmon). You see, I was also told at my corporate finance sessions to treat preferred stock as equivalent to debt and while this may still apply for cash flow claims when the going concern is, well, still going it may not hold once the butcher's bill is to be settled.

In a more fundamental light Paulson's swan song as treasurer was of course always going to be about Fannie and Freddie's creditors. As such, it will be interesting to see how they, and especially the foreign SWF and central bank vintage, will dissect the deal. One technical point here would be the extent to which spreads will decline in any meaningful way after the nationalization. In general though, this specific debacle is nothing but a few, albeit distinctive, steps in the US's dance macabre with its creditors in the form of predominantly foreign owned state and central bank investment vehicles. One important point in this respect, as I have argued extensively, is the nature of inflows into the US and how they can be seen as a natural counter product of foreign economies’ thrift. Add to this that the US still resides over the most liquid asset market in the world and you have an important part of the equation. I still do think this is an important point to make clear in a world where Bernanke, Greenspan and other of their US ilk are exclusively blamed for the mess in which we are currently sitting. Stephen Jen appears, I think, to be right on the money in his account of how foreign central banks will see the nationalization. They don’t like it, but they got what they wanted in terms of the US government’s guarantee that whatever plug is left in the Bretton Woods II edifice it would not be pulled by allowing Fannie and Freddie to fail. What remains to be seen though is whether investors will shun agencies and buy treasuries in stead. Obviously and if we assume that the spread does not narrow, any substitution away from agencies would actually help the US finance its ongoing liabilities at a lower cost.

In general and as you might expect, the econsphere is awash with thoughts on this. I would in particular recommend John Hempton and his recapitulary post on his thoughts as well as Barry Ritholtz' presentation of some of the gory details.

Europe Deteriorates Further, Will Trichet Fold?

This is starting to look almost as de-coupling in reverse as the data from Europe now indicate that the Eurozone as well as its immediate surroundings (e.g. the UK and many parts of Eastern Europe) are faltering. The ECB chose as expected to keep rates steady and although Trichet did not have the courage to openly voice a dovish bias (which would probably have gutted the Euro) it seems clear that the ECB has left its distinctive hawkish bias that was maintained for the most part of H01 2009. This is understandable, but the key question remains whether Trichet et al. will move in already towards the end of this year with a rate cut. As always, Germany remains the key and while the Q2 slump was expected due to the above par Q1 figure I really don't see how Germany can expect to recover in any meaningful sense of the word. I think it is crucial to consider the nature of Germany's growth path as one of export dependent as well as the general slowdown in global activity.

It should be noted in particular in this regard that private consumption has actually contracted in Germany over the last three quarters. Now that exports are faltering Germany, not unlike New Orleans during the hurricane Katrina, will see its last fortification be washed away. Adding to the gloom, we learned yesterday how German exports continued to decline in July with a rate of 1.7% from June. Especially the strong trade link, on the margin, with Eastern Europe is important to watch and with all the problems brewing to the east at the moment, one cannot help but feel that Germany may be the first to take a blow.

On that note, it also appears that all those looking for a soft landing in the Baltics may now finally have to concede to the rest of us. The latest news of the region informs us that Latvia joined Estonia in seeing a recession in Q2. According to Nordea, both Latvia and Estonia are set to contract on an annual basis in 2009 and that, in my book, is a hard landing. What happens next will be an important test for many a hypothesis. First of all there is the question of the pegs. My feeling is that the pegs will come under scrutiny as per reference to the lacking mechanism for correction. Basically, Latvia and Estonia now needs to export and subsequently reduce their external balance, but that may be difficult as long as the currencies are bolted to the Euro. Ultimately though, much will depend on the ECB here and given my predictions that they too will fold in 2009 a weaker Euro may shield the pegs from too much heat. Yet, one should not be fooled. The risk and, in fact, need of substantial wage and price deflation seem imminent and it is unclear how this will play out politically.

The Dollar Smile Continues

Just as the USD was beaten like the proverbial mule in H01 2008 so is it shining like a bright start so far in H02. I think that two key points stand out. One is the recoupling of e.g. New Zealand and Australia to the US style response to the credit crisis of cutting interest rates. Obviously, the rate differential still offers much juice for potential bets on the carry trade wheel, but the it is clear that the market has moved with interest rate decisions. The Aussie consequently moved close to the $0.70s, at 0.80, the past week and the Kiwi was also scythed as it touched $ 0.67.

In terms of the Euro and Sterling the price action have also, so far in H02, been extraordinarily positive for the USD. Especially, the sentiment on the UK economy have chilled decidedly as of late with the economy posting zero growth rate in Q2 as well as a barrage of bad news. Not least the continuing black hole of value destruction that once was a burgeoning housing market is weighing heavily on markets and, by consequence the BOE’s resolve as rates were kept a 5% last Thursday. Even with the growing storm clouds over the economy, the subsequent market reaction towards the pound is still quite extraordinary. Sterling was thus absolute pummeled last week as it declined to $1.77ish against the USD; these are levels not seen since April 2006.

As regards the EUR/USD, Trichet and his council continued to hold on to their put option entitling them to raise rates even as the economic structure crumbles. With recent comments by council member Jürgen Stark that second round effects have indeed materialized, the ECB is frantically trying to throw gasoline on what must now be a dwindling blaze around those hikers still trying to catch a thrust of heat from the hawks’ camp fire. But will it work? It does not seem that investors are buying the ECB anymore and that ultimately may one of the dear lessons to be paid by the ECB in its most valiant attempt to stay vigilant on inflation.

Apart from the interest rate differential story and also what essentially prompted the invocation of the dollar smile in the first place, there is the point on how funds tend to flow back to the US in times of trouble. This would then be a plain vanilla story of safe haven currencies and how the USD naturally commands such a position, not least in the context of US domestic investors who are otherwise, and very eagerly, shipping funds abroad. Stephen Jen consequently suggests how especially US life insurers, mutual funds, and private pension funds will behave in a manner which may be conductive for the USD (i.e. by repatriating some of their non USD holdings). Elsewhere, Jen also makes the interesting point that the rally in the EUR/USD may not have ended as private investors are yet to reduce their long exposure towards the Euro. Given the ultimate argument of the USD as a safe haven unwinding of this exposure would bring further upside for the USD.

Stephen Jen also makes the following point with respect to the JPY and the tug-of-war between risk aversion and capital outflows.

“While there might be modest safe haven flows into the JPY, we believe that the magnitude of the potential JPY rally will likely to be limited.  After the Bear Sterns crisis in mid-March, USD/JPY did sell down to 97.  However, after the GSE crisis in mid-June, USD/JPY only managed to correct to 105, disappointing many hedge fund investors.  We believe that Japanese investors have learned to keep capital outside Japan, by diverting their investments from Australia and New Zealand to the likes of Brazil and Turkey.  We expect this pattern of investment to persist, and therefore USD/JPY should stay higher than the fair value.  The key risk is that, if the global economy slows dramatically, even BRL and TRY could be jeopardised, and this could trigger a more powerful repatriation back to Japan.”

I would file this under ‘I wish, I’d said that’, and I really do think it gets to heart of the matter with respect to the JPY.

I am also intrigued to hear Jen mention Brazil and Turkey alongside the more traditional victims of Ms Watanabe’s gaze in the form of the Aussie and the Kiwi. Such flows would consequently be tantamount to the real and essentially long term de-coupling of the global economy.

However, for this to materialize we would also need a more asymmetric or, if you will, fine tuned version of the Dollar smile story to occur. In this way, and while I can see the impetus for the USD to regain some lost ground against the Euro, it is not in line with fundamentals for the USD to strengthen across the board. The external deficit and the subsequent need to re-direct the growth path of the US economy are drivers to suggest the opposite. However, it is here that many analysts loose their footing, although not I think Stephen Jen. Consequently, for re-balancing to occur in a sustained way the USD would need to stay weak against a number of key emerging markets such as precisely India, Turkey, Brazil, the Philiphines. So far, the market action does not support this with the USD strengthening significantly against major floating EM currencies as well as the JPY has also tested new highs on the decline in risk aversion.

Until something materially happens in this regard I am happy to stick with the Dollar smile scenario, but the smile needs to get a bit more uneven before true fundamentals are reflected. It is therefore precisely that the unfolding events in this crisis are crucial to watch in terms of gauging whether it is the same as before, or if something has changed.  

This is it for now in terms of my immediate thoughts for la rentrée. I see that as per usual markets are moving faster than I could ever hope to type, with Lehmann Brothers in the bushes today. Apparently, Lehmann did not manage to convince the Korean Development Bank to take part in what Brad Setser so poignantly cas referred to as the secret bail-out. This does not mean of course that a suitor won't step up, but it appears that it would take nothing short of J-LO's alter' ego in one of Hollywood's many sub-par conceptions for Lehmann to make it out alive.

For more on this, I will suggest my readers to pay Macro Man a visit if anything, then to learn that even the pros are scratching their foreheads more than normally at the moment. I will try to keep up here at Alpha.Sources but until I get my hyperspeed 20 gig internet connection at home, I will be limping a bit relative to regular services.