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Monday July 14, 2008 - 10:08:49 GMT

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Forex Research - Dollar Bounces As GSE's Propped Up - Crisis Averted or Merely Delayed?

After gapping higher on the open EURUSD slipped back below the 1.5900 figure and traded all the way down to 1.5840 on the news

Talking Points
•    Japanese Yen: firms of 106.00 as equities bounce EURJPY hits record high
•    New Zealand Dollar: Retails Sales miss badly but unit recovers in Europe
•    Euro: Gaps up but then sells on GSE prop up plan
•    British Pound: PPI
•    US Dollar: no data on tap but all eyes on Fannie Mae auction

Dollar Bounces As GSE’s Propped Up – Crisis Averted or Merely Delayed?

After gapping higher on the open EURUSD slipped back below the 1.5900 figure and traded all the way down to 1.5840 on the news that the Federal Reserve Bank of New York will provide a primary line of credit to Fannie Mae and Freddie Mac “should such lending be necessary”.  The Sunday night announcement helped to calm capital markets with DAX and Footsie rising by more than 1% while Nikkei fell only slightly, as the risk of a systemic failure diminished for the time being.

Between them the two GSEs guarantee more than 5 Trillion dollars of mortgage assets. A bankruptcy of the two institutions could create a massive disruption in the financial system sending yet more capital flowing towards the euro as a safe haven bid. In contrast to the past year when the EURUSD was driven primarily by carry trade and yield considerations, in the last week, the unit has traded primarily a flight to safety instrument rising whenever US equities fall. Therefore its true reaction to the rescue of the GSEs will not be evident until US stock markets open allowing investors there to asses the merit of the Fed action.

While the initial knee jerk reaction in the US may be to rally the S&P, the longer term questions regarding Fannie Mae and Freddie Mac remain. Has the GSE crisis been averted or merely delayed? The answer lies in the underlying strength of the housing sector which in turn may be dependent on the price of oil. If energy costs continue to flirt with record highs, keeping gasoline permanently above the $4.50 level, US consumption and demand will continue to be slowly chocked off and any stabilization in housing prices will not occur.  The two GSE with an effective leverage factor of 68 to 1 will then find themselves in deeper trouble as the value of their assets deteriorate further.

Therefore we believe that today’s Fed announcement will not be the final chapter in this saga but rather the first as more capital will be needed to prop up the wounded giants. In the meantime the greenback may get its groove back if only for a few days as a relief rally runs through  the currency market especially if today’s 3 Billion dollar planned auction of Fannie Mae bonds proceeds smoothly.

Finally on the economic front which has been practically ignored as the macro themes have dominated trading UK PPI data printed a bit cooler than expected with the Input number coming in at 0.9% versus 1.2% forecast while the output increased only by 0.3% versus 0.8% projected. The news only confirms the latest string of data from UK showing a marked slowdown in economic activity and may convince the BoE to begin lowering rates sooner rather than later as price pressures are clearly easing.  
  Will EUR/USD Trade Back to 1.60?  Join us in EURUSD Forum



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