In a move that was more or less expected by most traders and investors across the world, the US government announced this past weekend its plans to take the reigns on Freddie Mac and Fannie Mae. However, what wasn’t expected was the reaction that would follow the bailout. There was a clear and notable sign of relief as risk appetite jumped for equities; but in other assets, the price action was surprisingly reserved or somewhat counterintuitive. In this report, we’ll go over some of the preliminary details of the bailout plan, review what kind of impact the news initially had on the major asset classes and forecast the ultimate fundamental and price influence this announcement will ultimately have the markets going forward.
The Plan
For the past few months, market commentators and policy officials had grown increasingly critical about the health of Freddie Mac and Fannie Mae – two government sponsored enterprises that hold or insurer nearly half of the mortgages in the US. With nearly $5 trillion in mortgages, the future of these two agencies held a considerable weight over the health of the US housing market and growth, and even the global credit markets. Theoretically, a collapse on that scale could easily have triggered the next leg of the credit crisis – one that would have been far worse than anything we have seen over the past 12 to 14 months. However, there was little to no chance that the government would let the lenders fail. So, the question became when – not if – the US Treasury would take over.
On Sunday, after heated speculation and many unconfirmed rumors, officials confirmed the Freddie Mac and Fannie Mae had been taken into a government conservatorship. In taking over, both firms CEOs have been ousted, the Federal Housing Agency has been put in charge and all dividends have been suspended. The more important details aren’t yet set in stone. Treasury Secretary Henry Paulson has hinted at a possibly putting up $200 billion to support both lenders; and he has opened up lines of short-term funding for both Fannie, Freddie and 12 other home loan banks.
The Currency Market
The History: To understand how this announcement would impact the currency market, we need to recall what has happened to the Forex market over the past year. After the subprime meltdown and the subsequent housing recession took hold, the outlook for the US economy and risk appetite crumbled. These are two distinct influences on the deeply liquid market. First, the US dollar plunged as the Fed was spurred to an aggressive pace of interest rate cuts and international investors feared the world’s largest economy was heading for a recession. The other unique concern surrounded the popular carry trade. Any strategy that flourishes in conditions where volatility is low and yield differentials are expected to grow does not do well when credit seizures are a constant threat and interest rates are slowed by growth trends.
The Future: After the US government confirmed its plans to take over Freddie and Fannie, the US dollar plunged and the carry trade rebounded from its lowest level in over two years. However, both this sharp moves were ultimately retraced. The EURUSD and GBPUSD pulled back 375 points and 500 points from their respective intraday highs. The response from the US dollar shows the question of whether the bailout will boost confidence in the US and its housing market and securities or if it merely hints at a more dire situation for the economy than originally expected. In this respect, the strength or weakness of a currency is determined by its fundamental outlook with respect to the forecasts for all its counterparts. Right now, the economic outlook for the UK, Japan and Euro Zone are still more ominous. However, this action will act to remind traders that the economy may not be as strong as second quarter GDP numbers suggest. If US data continues to cross the wires in the red, it will have a greater impact in chipping away at the dollar’s advance.
As for the carry trade, this news removes one of the biggest clouds hanging over the popular strategy. With the US government officially backing the $5 trillion in assets, the threat of any major defaults from these assets have been alleviated. However, this move has merely bought the officials more time. What is truly needed is a genuine rebound in the housing market and renewed confidence in lending. In effect, this bailout has saved a major player in the mortgage market; but it will not encourage a rebound in housing demand on its own. What’s more, the general cool down in global growth will naturally reduce interest in purchasing big-ticket items like homes while at the same time limits borrowing.
The Equities Market
The History: Since the subprime meltdown really began to take hold in the US last summer, equities have responded by eventually falling into a bear market. The media officially branded the major stock market indexes as being in a bear markets when the they dropped more than 20 percent from their record highs – set only months before. The biggest factor in this marked deterioration was the collapse in the housing market and credit crunch which would eventually have broader consequences for broad growth. However, the government’s efforts to curb the economic malaise have borne fruit in the past. Most notably, the rescue of Bear Stearns had a remarkable impact on price action and volatility in the months following its emergency sale.
The Future: The markets always look to history for precedence on how to react to unusual events. Certainly the rescue of Fannie Mae and Freddie Mac fit into that category. However, does the bailout of the once market-leading investment house fall under the same header as the government’s swooping in for the two major lenders? In the former example, the bailout was out of necessity and the bank’s books held a significant amount of debt that could be dumped on an already illiquid market. This time around, market participants were pretty certain that the Treasury would step in; and there was little doubt that full-backing of the US was already implicit through the firm’s ties to the government. However, despite the assurances in the Freddie/Fannie case, the market was selling off even before official announcement. This lack of surprise is reflected in the S&P Volatility Index (VIX). Now with this hurdle officially crossed, equity investors will return to their forecasts for economic growth and interest rate forecasts – both of which still do not bode well for stock traders.
The Credit Market
The History: Well before the subprime crunch, the credit market was responding to a slow turn in the US housing market. The massive defaults and failure of numerous hedge funds holding the previously top rated mortgage-backed securities merely catalyzed the move. Over time, market commentators began referring to the resulting panic selling and disappearance of any kind of demand as a liquidity crisis. While the market made its attempts to recover, the outlook for yields didn’t really start to show life until after the markets were assured that the government was willing to step in and stabilize the market with the Bear Stearns’ effort. That event – along with ongoing injections of liquidity by the Federal Reserve where high-quality Asset-Backed Securities (ABS) were accepted as collateral - eventually led to a slow but steady rebound in confidence behind counter-party risk.
The Future: Conditions behind the credit markets are different today than they were following the Bear Stearns’ bailout. Back in March, the investment bank’s failure was a surprise; and the joint rescue was seen as a sign that market participants and officials would act to salvage the markets. However, the good will that this effort supplied had clearly worn thin well before the Fannie and Freddie event. Risk premiums in the junk bond spread (the difference between yields on an index of investment grade debt minus the interest rate on the Treasury product the same maturity) have climbed ever since late June. Essentially, the collapse of Freddie Mac and Fannie Mae reflects two more major US lenders that have succumbed to the housing and credit crunch. Before these two market giants faltered, US banks were already failing at the fastest pace in 14 years. Another unique concern from credit market is whether international investors confidence in US ‘risk-free’ assets will be further damaged by the government absorbing the additional $5 trillion in liabilities.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
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