Tuesday, October 16, 2007

EURUSD at 1.42 has become a resistance point

EURUSD at 1.42 has become a resistance point on the charts. Whenever the dollar has gotten to this point lately, buyers have stepped in. I certainly did. I bought a small number of US dollars in order to buy a leveraged options position against the dollar. Here is my thinking on the issues.

Interest rates here in Europe will have to rise in order to combat inflation.

Europe's September Inflation Rate Rises Above ECB's 2% Ceiling

Energy costs in particular have spiked here in Germany. Eon and RWE, two of the biggest gas and electricity distributors have just announced price increases of 8.8% and 9.9% respectively. Don't even get me started about the price of gas for the car. (EU1.399/liter, approx. 4 liters to the gallon, 1.42 euros to the dollar. You can do the math.)

The members of the European Central Bank have been preparing the way for a rate increase in regular comments to the press, "ECB president Jean-Claude Trichet reiterated that economic growth in the eurozone remained robust and that inflation was subject to upside risks."

And from ECB board member Axel Weber, "...the bank may need to raise interest rates to a level that restricts economic growth in order to keep price increases under control." The Wall Street Journal sums it all up nicely, in one article. Interest rates have been held steady for now, but don't expect that to continue. The next meeting of the ECB will be on the 25th of this month.

While in the US there is a completely different situation going on. The problem of the subprime mortgages isn't going to go away any time soon. Over just the next 3 months there is something like 150 Billion dollars worth of adjustable rate mortgages to be reset to current interest rates. There is a superb chart floating around the internet apparently from Credit Suisse, who've had their own problems the with subprime market.

Foreclosure rates are already at twice the 2006 rate, and by the looks of that Credit Suisse graphic this tidal wave is only just starting. Mortgage rate resets will continue well into 2008. US interest rates will have to come down in order to protect both the borrowers and the lenders. It's only a matter of time.

Treasury Secretary Henry Paulson may be saying that he "has no interest in bailing out lenders or property speculators", but he may not have any choice. In fact, a certain level of bailout may be exactly what he's planning, in co-ordination with several of the largest banks in America.

The idea floating around is to build an 80 Billion dollar fund to be used to purchase the credit worthy mortgages, but the problem is not the credit worthy mortgages. Besides the problematic subprime mortgages total more than 80 Billion dollars worth.

What we have here is in fact a risk to the capital base of several large banks, should they have to sell off risky mortgages at fire sale prices. I guess it would be a good idea to have cash on hand, in order to cherry pick the portfolio when the selling really gets going. Apparently Hank Paulson thinks so too.

Let the Crash begin! (or the Fed can lower interest rates, save the financial system, and devalue the dollar).

A devalued dollar will have plenty of side-effects, all over the world. Exporting nations (Germany and the rest of the EU) will be badly affected, as will those who depend on US tourists. Those nations who peg their currency to the dollar (China, Saudi, and other oil producing nations) will have to do some hard thinking too.

With a devalued dollar, European economic expansion will have to come from lower government debt, and corporate cost controls and careful investment. New markets will have to be found for exports because the USA cannot be "the customer to the world" any longer. It won't be easy.

The USA has already overspent and those countries who's currencies are pegged to the dollar will either have to give up that peg, or be willing to import US-related inflation to their own markets.

Some of those countries are already moving away from their currency peg, The Chinese have held steady so far, but even the Chinese know that they cannot afford hyperinflation. They need to be able to buy resources that they don't already own, and they will need a balanced, tradeable currency to buy what they need. So far, they've been buying those resources with US dollars, earned from trade with the USA.

With the dollar in decline, how long do you think they will maintain their own currency peg, when the dollars they own are buying less and less product every day? I'm not expecting that soon, by the way. Just sooner, or later.

In the mean time all the world will continue to play the biggest game of "pass the buck" that has ever been seen. It is a game that is attracting fewer and fewer players every day, as the value of the dollar drips slowly away.


pythagoruz said...

Great post, you covered alot with all the links. I guess I am wondering at what point does China de-peg from the $US.

I mean are we close, no where near that point... I really have no idea. But if that happened I guess the stock market and the dollar would crash together. What do you think?

Well, Chinese ADR's would hold up pretty well I guess. Go JASO!

indigo-alien said...

China is the big guessing game, and they hate to have their hand forced over any issue. But pressure has been building on this one for quite a while. So, who knows.

The consequences would be similarly hard to predict. A lot will depend on how they go about things.

But they tend to be cautious and conservative, and slow as only a dictatorship of terrified men can be.

And those are their good points.

indigo-alien said...

Another interesting link; http://www.minyanville.com/articles/index.php?a=14482

Pay particular attention to this graphic; https://image.minyanville.com/assets/FCK_Aug2007/File/sg2007101634801.gif

Let's look for an update.

pythagoruz said...

Wow, thats a big outflow. I guess foreigners don't want to get stuck holding the bag on stocks like they did on mortgage backed securities.

That article brings up another good point: The ABX indices have been quietly making new lows lately, at least the B-series (subprime). Stay tuned for another credit crunch...