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Monday October 6, 2008 - 02:35:23 GMT
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The Uncertainty Principle

If markets are forced to choose between a known negative and an uncertainty they will favor the negative.
The sub-prime debacle and its dire effect on the American financial system have been on full display for more than a year. The attempts of the Federal Government and private investment to deal with the multiplying bank and credit problems are daily headlines. Yet as the crisis has worsened the US Dollar has begun a steady climb against its main competitor the euro. At the end of one of the most tumultuous weeks in American economic history the dollar had regained 85% of the ground it had lost since the credit crisis began in August 2007. Overall the dollar has added almost 15% to its value against the euro since July 15 of this year when it hit bottom.
The banking, credit and consumer problems in Europe have only begun to damage the European economy. The fear is that there is much more to uncover. The insouciant attitude of some official European figures has not allayed market concern that European officialdom is complacent about the credit meltdown. Comments from Christian Noyer the Governor of the Bank of France “that there is no drama in front of us” and from Peer Steinbruck the German Finance Minister that the US was “the source …and the focus of the crisis”, seemed detached from reality. Within days the German government was forced to arrange a 35 billion euro loan to salvage Hypo Real Estate the country’s second largest property lender. Authorities in Belgium, Luxembourg, the Netherlands, Britain, France, Germany and Iceland have been forced to rescue or recapitalize institutions operating within their borders. The credit crisis suddenly seems very European.
And then there is the European Central Bank (ECB). Jean Claude Trichet, the President, and the governing board have apparently realized that the European Monetary Union (EMU) has an economic growth problem and perhaps even a credit problem. At Thursday’s news conference after the board had left the rate unchanged at 4.25%, he said that the board had only considered two options, a rate cut or a hold and the vote for the hold had been unanimous. But his emphasis on the economic situation in the news conference afterward make it very likely that the board will cut rates at their next meeting or s sooner perhaps in a coordinated effort with central banks around the world. 
The difficulty inherent in a united monetary policy supported by fifteen different fiscal and tax policies answering to fifteen political regimes is about to be put to the test in the EMU.  
 In Ireland and Greece depositor withdrawals forced the government authorities to guarantee all bank deposits regardless of size. These moves infuriated other European banks who feared a run on their own deposits by customers seeking security. In the shaky condition of many banks, unable to borrow in the credit markets and harboring questionable securities on their books, a run on deposits could be disastrous. Regulators and government officials in several European countries were inundated with worried calls from bankers who feared the loss of their deposits. But the deposit guarantees in Ireland and Greece stand and illustrate the difficulty of a coordinated policy response to the credit crisis among fifteen national governments that have only one executive agency in common, the ECB, and only one policy under its control, monetary.
President Sarkozy of France proposed a 300 billion euro bailout fund that was promptly denied by Germany. He did however manage to convince Angela Merkel of Germany, Gordon Brown of Britain, Silvio Berlusconi of Italy, Jean Claude Juncker of Luxembourg to meet with him and the Jose Manuel Barroso the European Commission Chairman and Mr. Trichet the head of the ECB, in Paris to formulate an EU response to the crisis.  But with German opposition to a bailout fund, the meeting will probably not go far beyond its official task of agreeing on plans for stricter investment bank regulation to be put before the next G8 summit.
The Europeans have two problems in relation to the credit crisis and the impending recession. The ECB has kept its base rate at 4.25% too long and is far behind the curve in an economy that is or soon will be desperate for liquidity and credit. It is no doubt true that inflation will take some time to descend to the ECB 2.0% target. In the current economic environment that is irrelevant. This crisis has moved much faster and spread much farther than the ECB anticipated. At this point even a steady series of rate reductions could take a year or more to reach US levels. The credit contraction will soon start to bite in the productive economy and the ECB will be hard pressed to provide a timely rate stimulus.   
US authorities have concluded the credit problems are systemic and the best solution treats the whole rather than the separate failing institutions. In the US that is relatively easy, once the political side it motivated. In Europe a coordinated response may be hard to formulate and harder to implement. The piecemeal reply to failing markets will delay recovery and by concealing until the last minute weak institutions, foster fear about the safety of even quality institutions. The more uncertainty there is about the health of Europe’s financial institutions the greater the perceived damage. In a troubled environment uncertainty breeds panic and uncertainty will keep the euro on the defensive until the credit crisis abates.

Joseph Trevisani
FX Solutions, LLC
Chief Market Analyst

[email protected]

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