BNP Freeze Causes Carry Trades to Plunge and Central Banks to React in Liquidity Sque

There is no denying the fact that the subprime problems have now gone global. This morning, France?s largest bank, BNP Paribas SA announced that they were freezing withdrawals from three of their investments funds following the “complete evaporation of liquidity.” For BNP, this may not be a big deal because the three funds represent only 1.6 billion out of the 356 billion euros that they have under management, but for the rest of the world, this is huge.

The victims of the subprime contagion is no longer limited to just small banks, and mortgage lenders, but is now hitting Tier 1 banks around the world. As a direct result of BNP?s announcement, overnight LIBOR rates skyrocketed to six year highs, stocks plummeted and carry trades sold off across the board. The situation became so severe that for the first time since 2001, the ECB stepped in and injected liquidity into the markets. The latest liquidity squeeze has broad ramifications for the global markets. Flight to safety will become the new trend, especially if we see a sharp increase in margin calls. Traders and investors will be moving back to cash, which in most cases means that they will be parking their money in US dollars. The greenback is already stronger against every major currency with the exception of the Japanese Yen and this is only because USD/JPY is a carry trade currency.
[B]ECB and Federal Reserve Step In[/B]
This morning the LIBOR rate rose by the fastest pace since June 2004, triggering a wave of concern amongst central banks. In dollar terms, the overnight lending rate jumped from 5.35 percent to 5.86 percent, a six year high. Euro rates climbed to 4.7 percent, while sterling rates hit 6.16 percent (both are new 6 yr highs). Fears of a credit crunch forced the European Central Bank to step in and inject EUR94.8 billion in emergency funds to calm the markets. The last time that the central bank injected liquidity was right after 9/11, which gives the market a gage of how serious the credit crunch has become. In fact, the amount injected in September 2001 was only EUR69.3 billion, 25 billion less than today. The Federal Reserve followed suit by adding $12 billion in temporary reserves via 14-day repurchase agreements. Unlike the ECB however, the Fed does repurchase operations every week, the only difference is that the repurchases today were more than double the amount done last Thursday. Both central banks are trying desperately to calm the markets. Even the Bank of Canada issued a statement saying that they are ready to add liquidity to the Canadian financial system, if necessary. Conditions must have deteriorated significantly because as recently as two days ago, the FOMC statement indicated that tighter credit conditions were not a threat. The same sentiment was relayed by the ECB last week.
[B]Is this the Beginning of the End?[/B]
The age of easy money is over and unfortunately, we expect more problems to come. We will not hit the peak in adjustable rate mortgage resets until October, when $50 billion in mortgages will switch to the current market rate. After that, $30 billion in mortgages will be reset through September 2008, followed by a sharp fall afterwards. This means that the risk of defaults and late payments will only continue to grow. Lenders will retrench further and if the problems exacerbate, it will also raise the risk of a recession. Volatility indices are up across the board indicating that risk aversion is growing. For the financial markets, this has broad ramifications:
[B]Market Ramifications[/B]
[B]Caution with Carry Trades[/B]: Long Yen traders will probably make out better than those who are still short Yen. Carry trades thrive in low volatility environments and the recent movements in the financial markets is anything but low volatility. Over the past few years, the popularity of carry trades has made speculation in Japanese Yen crosses a very leveraged bet. As a result, big moves lower could easily trigger margin calls. The principle of gravity applies well here - things fall much faster than they rise. According to one of our previous Carry Trade Special Reports, the maximum drawdown in a basket carry trades over the past decade was 10.5 percent. We have drawn down less than half that amount at this point.
[B]Further Losses in the Stocks[/B]: US stocks could also continue to suffer as investors reduce risk. In the first half of the year, leveraged buyout deals and stock buybacks fueled a sharp rally in equities. With the current credit crunch and liquidity squeeze, not only have these deals been cancelled, but we expect lenders to be far more selective in the months to come. Unless the Fed sweeps in with a 100 basis point rate cut tomorrow, do not expect the Dow to return to its all time highs. See our Special Technical report on the Dow and EUR/JPY.
[B]Rise in US Dollar[/B]: In contrast, as the carry trade and other leveraged bets become unwound, those assets will be parked back in US dollars for the time being. Do be careful however since the safe haven status of the US dollar could be counteracted by the possibility of the Federal Reserve lowering interest rates.

[B]Federal Reserve September Cut?[/B]: The futures markets have now fully priced in a 25bp rate cut next month. This is a sharp shift away from yesterday?s 20 percent probability. If this is true, the Fed will have to make some sort of announcement expressing their shift in stance. Although we do think that the subprime problems are severe, a September rate cut may be a bit premature. Yields on bonds have already fallen in response to the moves by the central banks today.
[B]ECB September Rate Decision[/B]: Unlike the Federal Reserve or other central banks around the world, the ECB is prohibited from bailing out banks or anyone for that matter. Therefore if the blowups escalate and yields to not regulate themselves, the ECB could change its mind about raising rates in September. For the time being however, current conditions should not alter the central bank?s plans to raise interest rates in September. They are offering liquidity at the current level of interest rates (4.00 percent) and not at a lower rate.
Today?s developments could be the beginning of a major shift in the financial markets but even if it is not and US stocks manage to recover most of its losses, it is still important for traders to be prepared because volatility has returned and it is not likely to go away soon. For those who still want to hold onto existing positions that have become vulnerable to recent market movements, it will be even more important to look into hedging your portfolio with different asset classes until calm is restored in the markets.

Written by Kathy Lien, Chief Strategist[/B]