It has been little more than two months since global markets were roiled by a collapse in the US subprime debt market prompting emergency liquidity infusions from the world’s largest central banks. Nevertheless, much of the losses from the massive flight from risk have been virtually erased. Does this hearty return of risk appetite suggest that the worst of the credit crunch is behind us? Or, could we experience another, perhaps more painful period of contraction?
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A Tumultuous Summer[/B]
It has been little more than two months since global markets were roiled by a collapse in the US subprime debt market prompting emergency liquidity infusions from the world’s largest central banks. Nevertheless, much of the losses from the massive flight from risk have been virtually erased. Does this hearty return of risk appetite suggest that the worst of the credit crunch is behind us? Or, could we experience another, perhaps more painful period of contraction? What will happen to the dollar, already at record lows and still vulnerable to further Fed rate cuts? To better understand what is at risk, it is important to recount the fallout from July and August, review what steps were taken to buttress the markets and analyze what risks still loom on the horizon.
The turn in global markets happened innocuously enough in mid-July. Though the equity, debt and FX markets were ominously correcting at the same time; their initial losses were modest. The gradual change in global investor sentiment through the summer began in the US as fears that the subprime mortgage sector was on the verge of collapse were suddenly realized. The first major casualty of a rise in subprime defaults was Bear Stearns’ High-Grade Structured Credit and High-Grade Structured Credit Enhanced Leveraged Funds. However, it wasn’t until hedge funds and banks outside the US borders reported losses from investments related to American mortgage backed securities that panic peaked. And, when the fuse of fear was lit, concern spread rapidly to all assets that were considered risky or otherwise overbought. In the currency market, the carry trade suffered extreme volatility and massive drawdowns. To grasp the change in market conditions, volatility in USDJPY (one of the most liquid carry trades) surged from an all-time low to a five year high in a matter of weeks. In terms of price action, the top yielding carry trades saw substantial declines: NZDJPY plunged 24 percent; AUDJPY sank 20.1 percent; EURJPY dropped 11.6 percent and USDJPY fell 10.1 percent. Equities saw similar extremes. The VIX volatility index jumped from 13 year lows to its highest level since the dot com bubble burst. In the fray, the Dow lost 10.7 percent. Proving the markets are truly global, the Nikkei dropped 16.6 percent and the FTSE 100 fell 13.8 percent in sympathy.
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Emergency Measures[/B]
With losses mounting, market commentators and seasoned traders started drawing correlations between current market conditions to previous market collapses like the one following the 1998 LTCM hedge fund blow up, the 1997 Asian financial crises, Black Monday’s more than 20 percent drop in the Dow Jones Industrial Average over one day in 1987 and even the stock market crash of 1929. As monetary policy makers caught on to the severity of the plunge, they moved in to try to stabilize panicked markets. The G3 central banks attempted to turn the ship slowly at first by injecting liquidity into the market through short-term loans. Through a number of injections, credit availability improved; yet markets continued to drop as the rise in fear outpaced the increase in available liquidity. On August 17th, the Federal Reserve took the unusual step of cutting the discount lending rate by 50 basis points in between its scheduled meetings and the markets found a floor that same day. Caution further turned to optimism on September 18th when the Fed followed up with an additional 50 basis point cut for the discount window, and more importantly a 50 basis point cut to the benchmark Federal Funds rate.
While the burden of a credit crunch has seemingly been lifted, officials have taken steps to try and ensure that another freeze is avoided. The Treasury Department is supervising the creation of a fund headed by Citibank, JPMorgan Chase and Bank of America called the Master Liquidity Enhancement Conduit fund. Expected to be as large as $100 billion, the mass of capital will be used to buy structured investment vehicles (SIVs) that were funded by commercial paper that is now thinly traded and difficult to price. This arrangement is expected to disperse risk among the banks and help to further loosen credit flows. However, there is still debate as to whether this will truly solve the problem or if this new structure is simply another way to transfer liability.
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Are Things Back To Normal?[/B]
After the central banks stepped up to bail out the markets and the details of the super conduit fund have emerged, many financial instruments returned to their pre-credit crunch norms. Volatility in equities, debt and currencies dropped significantly while implied volatility in the carry trade has fallen back to levels comparable to the 2005/2006 lows. The benchmark stock indices have similarly settled from their extreme down days of August. And, as volatility has been ushered out, bullish sentiment quickly returned. The FTSE 100 and Nikkei have rebound from multi-month lows to climb back towards their cycle highs, while the Dow Jones Industrial Average has actually moved on to set a new record. The carry trade has received similar reprieve as EURJPY and the other yen crosses have recovered a majority of their lost ground.
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Problems Beneath the Surface[/B]
However, though investor sentiment seems to be on the rebound and many of the popular investments have returned in strength, many problems are still floating just below the surface and officials and traders are just now starting to appreciate their possible long term consequences of the fallout. One glaring sign that the credit crunch has merely gone into hibernation is the big hit to earnings the major US banks reported over the third quarter. Credit Suisse reported a $1.56 billion and $1.35 billion write off on subprime and leverage debt losses. UBS wrote a $3.42 billion hit from mortgage backed securities off its books. Perhaps the most shocking so far, Merrill Lynch announced a write down of $7.9 billion in losses from subprime loans and collateral debt obligations (CDOs). Even Goldman Sachs, the premier bank on Wall Street, who reportedly had a positive quarter, saw most of its profit in unrealized gains while ‘hard-to-value’ assets were pushed to the background. Despite the mark downs on the books, it is still not clear whether further losses will carry over to the fourth quarter. What’s more, the depressive impact on lending is already evident in other areas of the financial services group and even in other sectors.
Another problem that has received greater media attention recently is the existence of SIVs in money market funds. Typically considered one of the safest and most liquid areas for investment, a number of these funds have admitted to investing in the same ‘high-finance’ derivatives built on subprime loans that have cut into banks’ earnings. A report by The Wall Street Journal suggests a number of major money market mutual funds run by names like Credit Suisse Asset Management, Bank of America and Federated Investors were holding 10 to 20 percent of their total portfolios in SIV created debt. Should there be another sudden run for the doors in the credit market, even the most liquid assets may come under fire and a run on the money market finds could be the 21st century equivalent of a run on the banks.
Finally, taking the credit crisis full circle, the next global market shock may find its epicenter in the US housing market. After so many hedge funds and banks have reported crippling losses from subprime and other mortgage backed securities, there are still a substantial number of mortgages that may fall into default in the near future. This looming danger exists because many of the mortgages taken out during the boom years of US growth from 2002 to 2007 were adjustable rate mortgages (ARMs) that were initially set with a low ‘teaser’ rate and will later reset to an interest rate based on the prime rate at the time of adjustment. A record $50 billion worth of these loans are set to adjust in October alone and an estimated 2 million homeowners with ARMs are expected to be reset by the end of 2008. The latter statistic is particularly concerning considering 80 percent of those carrying ARMs deemed ‘current’ on their payments only make the minimum payments. The rate adjustment or perhaps a drop in income could easily push thousands more into default. As it stands, the Federal Housing Administration expected a quarter of the 2 million owners set for adjustment to be forced into foreclosure.
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Currency Impact[/B]
Taking all these potential problems into consideration, what is the presumed impact on the currency market? First of all, should any one of these looming threats trigger another flight from risk and threaten financial markets and growth, the Federal Open Market Committee would likely step in with additional, potentially large cuts to the Federal Funds rate. While the immediate impact of yet another wave of risk liquidation would actually be positive for the dollar as the carry trades unwind, the long term consequences are likely to be dire. With the greenback already pushing record lows on a trade-weighted basis, the currency could continue to ratchet new lows against its major counterparts as interest rate differentials compress further. A run on the dollar could easily lift EURUSD to 1.4500, GBPUSD to 2.1000, and carry USDJPY down to 110.00. The USDJPY pair, once the preeminent carry trade vehicle, is already showing signs that the dollar is loosing its clout. While the greenback still enjoys a considerable 4.25 percent yield advantage over the yen, the pair has gotten nowhere near its former swing high at 124.00 in the rebound from mid-August lows as traders worry about further US rate cuts. Taking a much longer-term outlook on a second round credit crunch, the US wouldn’t be the only economy to feel the impact. The waning demand from the US economy for goods from countries like Japan, China and UK, among others, would slow global growth and could ultimately mark a bottom for the greenback. In the meantime, however, the buck could be in for more pain.