In the third quarter of 2007, US GDP registered a gain of 3.9%. On the other hand EZ GDP for the same period is expected to grow at only 2.5%. On the employment front US Non-Farm Payrolls printed at 166K nearly twice the anticipated rate of 88K while unemployment rate has remained at a low 4.7%.
Meanwhile in EZ unemployment while improving continues to hover at 7.3%. Finally despite two rounds of rate cuts US short term interest rates remain 50bp higher than those of the Euro-zone.
Given this set of economic statistics, how is it possible that the dollar now finds itself at record lows against the euro? The pair hit 1.4700 in overnight trade, and is now within striking distance of the 1.5000 figure. The answer to that question lies with the US housing sector, and more specifically with its impact on the US financial sector. Furthermore, these problems may be structural in nature and could weigh on the dollar for months to come.
[B]The Fall of Housing[/B]
The collapse of housing has been an ongoing story in the US economy for well over a year. Housing statistics have been nothing short of disaster as new home sales have contracted to 770K annual run rate, almost half of it peak of 1389K units in July of 2005. Existing home sales also saw a massive plunge as volume decline to 5.04M units from 7.21M in September of 2005. Yet the housing sector, though clearly in a recession, is only directly responsible for just 5% of US GDP. So why are housing woes having such a massive impact on the US dollar?
[B]Collateralized Debt Obligations – The Unknown Risk[/B]
During the peak years of the housing bubble, credit standards in the US mortgage industry were loosened considerably. Armed with adjustable rate mortgages, financial institutions extended nearly a trillion dollars worth of loans to very risky creditors. Furthermore, all of there mortgage loans were packaged into securities and sold to investors as fixed income instruments known as CDOs – Collateralized Debt Obligations. As interest rates rose and housing values plummeted, many of the mortgages holders during the 2004-2006 period began to default on their loans sending the value of the CDOs markedly lower.
However, the problem with these instruments was compounded further by the fact that investors who bought these securities chose to leverage their positions. An article in the Financial Times of London, starkly spells out the dangers of this strategy, ““Imagine a typical hedge fund, two times levered. That looks modest until you realize it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralized debt obligations, which are nine times levered. “Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital - a 2% price decline in the CDO paper wipes out the capital supporting it.”
Indeed it’s the deadly combination of very poor credit quality and very high leverage that created such massive problems for the financial sector. The new accounting rule SFAS157 requires banks to divide their tradeable assets into three "levels” according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets and can be marked to the market. Level 2 assets are marked on a comparable basis by observing prices for similar assets and finally Level 3 assets – the most controversial of all - are known as “marked-to-the-model” assets. These are securities for which no market value exists and which are valued strictly on a theoretical basis by the financial institutions that hold them.
Therein lies the biggest problem facing the US dollar. Almost all of the large US financial institutions have recorded massive amounts of CDO assets as Level 3. In fact in a very controversial piece of research first reported by Nouriel Roubini, the ratio of level 3 assets to shareholder equity often exceeds 100%.
Following is a table that shows the exposure of some of the largest US financial institutions to the CDO risk
[B]Fed May Be Forced To Continue Cutting[/B]
Given the deep credit problems, the currency markets are convinced that the Fed will have to continue to lower rates irrespective of the generally positive US economic data. This of course is occurring at a time when the rest of the world is tightening monetary policy. This juxtaposition is creating the one way bear market in the dollar as interest rate differentials between the greenback and the rest of the world continue to compress. Already 2 year swap rates are higher in Eurozone than in the US for the first time since 2004. This is an implicit bet by the fixed income traders that US rates are headed lower.
[B]How Low Can the Dollar Go?[/B]
Recent price action in the EURUSD suggests that the juggernaut may not stop at least until 1.50 level is breached. Our own internal data from the FXCM SSI shows that positioning has not reached extremes, as traders continue to fade the move. There are still enough euro skeptics left in the market to push the pair higher. The dollar rebound is unlikely to come until SSI positioning flips to positive and everyone decides to join the move. For the time being it looks like the greenback may be in for more pain.
[B]Written By: Boris Schlossberg, Senior Currency Strategist[/B]