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Thursday December 13, 2007 - 12:50:19 GMT
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Mr. B's Wild Ride

FX Trading – Mr. B’s Wild Ride

The rollercoaster ride began on Tuesday after the Federal Reserve’s interest rate announcement. That’s when the Fed statement delivered a double dose of 25-basis point rate cuts – in both the Fed Funds and the Discount rate.

And according to the price action following the announcement, the Fed didn’t do enough to comfort banks and alleviate the credit problems. Markets might as well have shouted in unison, “We wanted 50!”

By the time Tuesday finished up risk-appetite had been wiped clean off the table -- stocks plunged, yen rallied and commodity-dollars sank. There was no hope left for liquidity.

Enter Wednesday …

Even before U.S. markets opened up the day, breaking news energized the markets. A complexly orchestrated scheme involving five global central banks would solve the credit problems and free up liquidity.

The knee-jerk expectations:

* No longer will banks be humiliated and left with no other choice but to borrow from the Fed’s discount window … the Bailout Boys are here.

* No longer will banks be reluctant to lend money to consumers and businesses … the Bailout Boys are here.

* No longer will recession be breathing down our necks … the Bailout Boys are hear.

And according to the guys on CNBC that love to hear themselves talk, this is exactly what’s needed to save the day. Liquidity is back -- thank you Bailout Boys!

The scheme, coordinated between the Federal Reserve, Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank, is to lend out $40 billion in separate auctions at rates significantly below the Fed’s discount rate. There are also some added kickers to help the plan along.

Initially it’s tough to tell if this plan will work. But you’ve got to give the guys some credit for getting creative this time around. I see the good and the bad of it:

The Good: the action is focused. Instead of rushing in to cut the Fed Funds rate to zero, this approach is aimed only at the trouble spots. It’s the banks who’ve gotten themselves into trouble with investments in complicated bundles of bad debt. The efforts to save them shouldn’t run the risk of weakening them in the process to prove that point. [I realize that those of us who yearn for the invisible hand to reach out and smack the overzealous would argue this point.]

The Bad: the action is limited. $40 billion dollars isn’t enough to solve the problems for heaps of banks up to their neck in this mess. The participating central banks will likely need to go further with the amount of money up for auction. [Not that all derivatives are bad, only a small slice of them are.  And derivatives have allowed for some very efficient financing that has built solid growth and real wealth.  But the relative size of the derivative market compared to the firepower of all the central banks combined is scary.  Morgan Stanley estimated there were $415 trillion in total derivatives outstanding at the end of 2006.]

The ultimate goal is to give banks the confidence to lend money. This will keep the economy flowing and help to narrow the spread among key rates. The rates that matter most right now: mortgage rates. If these rates can be successfully reduced, we’ll begin to see the housing problems reside, is the plan.

After all, that’s how this whole mess got started.  [Well, it really got started because rockets scientist created stuff in the lab that acted a lot differently in the real world where econometrics and rational expectations can become very screwed up.]

So hand it to the Fed: they’ve finally let us know they can get creative when push comes to shove.   But we need to see some market follow-through before we start handing out the “You Geniuses Saved the Economy” awards.

Markets aren’t exactly satisfied and seem to realize the liquidity squeeze isn’t an easy fix. Asian markets fell, and as you know, US stocks gave back almost all of their gains yesterday.  A lack of follow-through by the markets isn’t reassuring that anything yesterday was fruitful.  Maybe we will see another round of coordinated liquidity pumping from the big five. 

But, we have to be open to the idea that sometimes you can lead a horse to water but you can’t make him drink.  We seem to remember the Bank of Japan had a similar problem back in the mid-1990s.  With interest rates at zero, borrows in Japan couldn’t be found.  The end of that story wasn’t pretty.

Stay tuned. 

John Ross Crooks III
Black Swan Capital


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