"it is best to cut costs and jobs as early in the downturn as possible"

More evidence of what I call a Proactivity Run. From Reuters:

NEW YORK (Reuters) - For a global industrial company facing slowing markets, shrinking developed economies, and the headwind of a rising U.S. dollar, it is best to cut costs and jobs as early in the downturn as possible( THIS IS WHAT I CALL A PROACTIVITY RUN. LAYING OFF WORKERS BEFORE YOU'VE ACTUALLY SEEN A DECREASE IN DEMAND. ), Eaton Corp (ETN.N) Chief Executive Sandy Cutler said on Monday.

Deciding where to cut, and how deeply, poses a challenge to even the most experienced management team, said Cutler, whose company has cut about 8,600 full-time jobs, or 10 percent of its work force, over the past year.

"It's hard to estimate when markets will bottom and then how long they'll be there," Cutler said in an interview. "The management team has been through multiple recessions, and knows you have to attack cost structure very early. If you don't attack them early, you can never get ahead of them."

A slowdown that initially hit the financial sector( A CALLING RUN ) has now moved to manufacturers, he said, and this is the first simultaneous, liquidity-driven ( DEBT-DEFLATION ) downturn since the Great Depression. Its speed, meanwhile, is faster than past recessions( DUE TO THE CALLING RUN. ).

"We were really trying to make these (jobs) decisions in the October time frame, and we've seen in almost every month, the outlook keeps getting darker."

Eaton, which provides detailed economic and market forecasts when it reports quarterly earnings, said Monday that economic models created after recessions in the 1990s and 2000s are "not tremendously helpful( OF COURSE NOT )."

As a result, the diversified industrial manufacturer issued a much wider-than-usual 2009 earnings forecast on Monday, estimating full-year operating profit in a range of $4.20 to $5.20 per share. In the past, the range was about 50 cents, Cutler said. Eaton said it may have to cut costs further as conditions change.

Eaton estimates U.S. gross domestic product will contract in each of the first two quarters of the 2009, on top of a steep expected contraction in the fourth quarter of 2008. The government is set to report fourth-quarter GDP data on Friday.

Separately, Cutler said the recent strength of the U.S. dollar was a key variable this year, and under current estimates, it would reduce 2009 sales by about 6 percent. The euro as well as the Brazilian and Chinese currencies, are the most important to Eaton's outlook, Cutler said.

The currency impact comes against the backdrop of shrinking U.S., European and Japanese economies, and rapidly slowing growth rates in Brazil, India and China.

"You're getting a double whammy from the change in the value of the U.S. dollar as well as this contraction," Cutler said.

Earlier, Eaton reported a lower quarterly profit, but the results beat Wall Street estimates.

(Reporting by Nick Zieminski; editing by Jeffrey Benkoe)"

As I say, more evidence of what a Proactivity Run is.

To understand why China purchases US debt one has to look at the manufacturing and distribution model

A good post from The Elephant Bar:

"Why China Purchases US Debt

To understand why China purchases US debt one has to look at the manufacturing and distribution model. A totally vertically integrated company, or for that matter, a country would manufacture and sell its products directly to the consumer.

Each stage of the process would have a cost and would require a profit. A farmer would raise his own eggs and sell (trade) his surplus to his neighbor. That was how commerce began. There was no such thing as outsourcing. All costs and profits, or losses were born by the farmer. Modern society is far different.

The manufacturing and distribution process has evolved into specialists who manufacture, distribute or sell products. When China decided to get into the game of world commerce, she assessed her structural weaknesses and strengths( TRUE ). The US was a powerhouse of distribution and sales. It simply was not possible for China to set up a retail or wholesale distribution in the US which represented almost a third of global consumption.( TRUE )

Chinese strength rested in low cost manufacturing. Low cost manufacturing can be dependent on well chosen capital or intensive use of low cost labor( YES ). China used low cost labor to build capital( TRUE ).

The huge US market was open to China and welcomed low cost Chinese produced goods. US branding of products could easily allow retailers to sell American named goods produced in China.

A $90 Black and Decker appliance, made in China, could be sold for $80 to a consumer with a greater profit to the retailer than a US produced unit. China made the product and gleefully took the dollars. The Question was what to do with them?( TRUE )

The Chinese had little need for US products but a huge need for the dollars. The currency generated could be redeployed globally through banking, distribution, construction or for internal financing of capital or infrastructure. China bought US securities( BONDS ) with the trade dollars because there was nothing better or smarter for them to buy( I'M NOT SURE ABOUT THAT ). They bought a lot of securities because they had the excess cash from export.

Today China will buy US securities based upon its trade with the US. If the US slows in buying Chinese goods, China will buy fewer US securities because it has fewer dollars. If China needs more money for internal consumption, it may have to sell US securities to raise cash( TRUE ).

China will not be selling or refusing to buy US securities because they are mad at us. If China wants to sell in the US, it must take dollars and either spend them or invest them. There is no other way( TRUE ).

_______________________

U.S. Rates to Stay Low as China Cuts Debt Purchases


By Kevin Hamlin and Judy Chen

Jan. 8 (Bloomberg) -- U.S. Treasury yields are unlikely to climb significantly should a decline in China’s foreign-exchange reserves force the nation to scale back purchases of the securities, according to Fitch Ratings Ltd.

The New York Times reported yesterday that China is losing its appetite for debt from the U.S. and said this could have “painful effects for American borrowers.” Demand for Treasuries remains robust with investors shifting out of riskier assets( THE FLIGHT TO SAFETY ), and yields on 10-year bills are close to historical lows, said James McCormack, the Hong Kong-based head of Asian sovereign ratings at Fitch.

“China is going to buy less Treasuries but only because foreign exchange accumulation is not going to be so large,” he said. “It’s not as though they are shying away from Treasuries and buying something else( I AGREE ).”

China’s currency reserves, the world’s largest at about $1.9 trillion, recently fell for the first time in five years, Cai Qiusheng, who works for the State Administration of Foreign Exchange, said last month. With less dollars flowing into the country, China’s need to buy U.S. debt is reduced( TRUE ).

The total amount of U.S. government debt outstanding rose to $10.7 trillion in November, from $9.15 trillion a year earlier, as the government bailed out financial companies. President-elect Barack Obama, who takes office on Jan. 20, is pressing Congress to approve an economic stimulus plan of about $775 billion over two years.

Global Recession

“The likely scale of China’s reduced( WHICH WOULD LESSEN DEMAND AND RAISE PRICES ) purchases will not be enough to overwhelm other global factors that are pushing down rates,” said Brad Setser, a fellow at the Council on Foreign Relations in Washington.

The yield on the benchmark 10-year Treasury note was recently at 2.50 percent, compared with an average 3.64 percent last year. It reached a record low of 2.0352 percent on Dec. 18 as recessions in the U.S., Europe and Japan boosted demand for the safest assets( FLIGHT TO SAFETY ).

U.S. Deputy Secretary of State John Negroponte downplayed questions about potential conflict over how China handles its holdings of Treasuries while visiting Beijing today.

“My Chinese interlocutors pointed out that they have been very responsible in dealing with the question of the American debt that they do hold, and they want to be viewed as a reliable partner in that regard,” he told reporters at a press conference today in Beijing.( TRULY SPEAKING, THEY DO NOT WANT THE SAVER COUNTRY/SPENDER COUNTRY SYMBIOSIS TO END. )

Deepening Crisis

Zhu Guangyao, the Chinese Assistant Finance Minister, said on Dec. 5. that China may continue to buy U.S. Treasuries to help stabilize the American financial system as the global financial crisis deepens.( AS I SAID, THEY REALLY, REALLY, DON'T WANT THIS SYMBIOSIS TO END. )

The latest data shows China continues to have a strong appetite for U.S. debt. In September it passed Japan to become the largest overseas holder of Treasuries. China’s holdings of the securities increased $67.5 billion in October to $652.9 billion, according to Treasury Department data.

That level of purchases is probably unsustainable because China’s reserves growth has slowed, said Setser. Data on China’s foreign-exchange reserves at the end of December are scheduled for release next week.

The reserves may have declined due to “changes in valuations of assets( PRICES ), especially in euro-denominated assets,” Chinese central bank adviser Fan Gang said Jan. 6.

Euro’s Decline

The euro has fallen 18 percent against the U.S. dollar from its record high of 1.6038, touched on July 15.

China’s reserves may decline in the first half of 2009 as a pause in the yuan’s appreciation prompts speculators to pull money out of the country, Moody’s Economy.com said on Dec. 30.

Other factors that may slow growth in the reserves this year include a possible narrowing of the trade surplus( LESS MONEY FROM EXPORTS ) and less foreign direct investment.

China’s trade surplus may have dropped to $34 billion in December, from a record of $40.09 billion in the previous month, according to the median estimate in a Bloomberg survey of 17 economists.

China should diversify its currency holdings away from Treasury bills because credit default swaps show they are “a relatively big risk,” former central bank adviser Yu Yongding said Dec. 12.( THIS WAS MY EXACT POINT EARLIER. IN MY OPINION, THEY SHOULD HAVE STAYED IN AGENCIES. THEY MISREAD THE LEVEL OF GOVERNMENT GUARANTEES ON AGENCIES. )

Such diversification is not easily executed, said Stephen Green, head of China research at Standard Chartered Bank Plc in Shanghai.

“We still have the same old problem,” he said. “There are not many other places to invest the money.”( THERE ARE, BUT THEY ARE VERY CAUTIOUS. )

Posted by 2164th at 1/10/2009 06:05:00 AM

“Our strategy for 2009 is to gradually increase risk"

Some good news from Bloomberg:

"Dollar Rally Fizzling as Fed Triggers Risk Appetite (Update3)
By Bo Nielsen and Ye Xie

Jan. 5 (Bloomberg) -- The dollar, yen and Swiss franc may weaken this year against 2008’s biggest losers in the currency markets as the global economy starts to recover, the largest foreign-exchange strategists and investors say.

The winners will be the Brazilian real, Indonesian rupiah and Polish zloty as investors return to higher-yielding assets, according to Bloomberg News surveys. The dollar may strengthen versus the euro and Japanese yen, while dropping against the British pound.

“Our strategy for 2009 is to gradually increase risk( GOOD ),” said Maxime Tessier, head of foreign exchange in Montreal at Caisse de Depost et Placement du Quebec, which is Canada’s largest pension-fund manager, with C$155 billion ($130 billion) in assets. “A year from now, I definitely want to be on the short side on the dollar. We’ll see capital flows out of the U.S. again( WE'LL BE PAYING TOO LITTLE INTEREST, AND THE FLIGHT TO SAFETY WILL HAVE ABATED. ).”

While the International Monetary Fund cut its 2009 growth forecast for the world economy to 2.2 percent in November from 3.9 percent, investors are growing more confident( TRUE ) as central banks lower interest rates and governments earmark trillions of dollars for fiscal stimulus( AS THE GOVERNMENT INTERVENES. GOT THAT. ). The Dollar Index that tracks the currency against six of the U.S.’s biggest trading partners fell 6 percent last month, the most since July 1985, after rising 18 percent from June to the end of November.

The dollar lost steam as the Federal Reserve cut its target rate for overnight loans between banks to as low as zero and poured $8.5 trillion into the financial system. Treasury yields fell to records last year and rates on bills dropped below zero( ZIRP ) last month for the first time as investors sought the safety( EXPLICIT GUARANTEES ) of government debt.

Survey Results

Faster economic growth will cause the dollar to weaken to 2.30 against the real from 2.3145 at the end of 2008, according to the strategist surveys. The rupiah may follow, gaining 11 percent against the dollar to 9,850 by the end of 2010, while Poland’s zloty strengthens 13 percent to 2.62 in two years, the surveys show.

The pound may strengthen 3.5 percent to $1.51 this year, while the euro will depreciate 8.4 percent to $1.28, the strategists said. The yen, last year’s best-performing major currency, will lose 10 percent to 100 yen, they said.

Lawrence Goodman, head of emerging market currency strategy at Bank of America Corp. in New York, said countries that prove better at withstanding the global slowdown should benefit as the flight to safety slows( YES ). The dollar will decline 18 percent against the real and 19.5 percent versus the zloty, he said.

Dollar Bear

“The U.S. dollar will get weaker versus emerging-market currencies,” said Mark Mobius, who oversees about $26 billion in developing-nation assets as executive chairman of Templeton Asset Management Ltd. in Singapore, in a Dec. 24 Bloomberg Television interview. “The reason why we had this weakness in emerging-market currencies is because of the rush into the U.S. Treasuries, into dollars. I don’t think that’s sustainable( I AGREE ).”

Investors see little need to hold dollar assets( THIS IS BUITER'S WORRY ) as the Fed floods the world with greenbacks, the U.S. budget deficit swells to more than $1 trillion and with the trade gap exceeding $57 billion. China cut the share of dollars in its $1.9 trillion of reserves to about 45 percent last year from more than 70 percent in 2003, Deutsche Bank AG in Frankfurt estimates.

U.S. efforts to fix the financial system and the stimulus package promised by President-elect Barack Obama may still support the dollar by helping the world’s biggest economy recover faster than Europe and Japan.( TRUE )

Japan Outlook

Japan’s economy will probably shrink( AN EXPORT COUNTRY ) at an annual 12.1 percent pace this quarter, the sharpest drop since 1974, after reports showed industrial production and exports posted the biggest declines on record in November, Kyohei Morita, chief Japan economist at Barclays Capital in Tokyo, said last week.

By the end of 2009, the U.S. economy will be growing at a 1.8 percent annual pace, while the euro zone will be shrinking at a 0.4 percent rate and Japan will be expanding 0.4 percent, according to Bloomberg surveys.

Deutsche Bank, the world’s biggest currency trader, is among the most bullish on the dollar( IN THE SHORT RUN ), forecasting a rally to $1.20 versus the euro, and to $1.30 against the pound, as the European Central Bank cuts its target rate to 0.75 percent this year from 2.5 percent, and the Bank of England lowers its benchmark to 0.5 percent from 2 percent.

Bank of England policy makers meet Jan. 8 and are likely to lower their target rate to 1.5 percent, according to the median estimate of 50 economists surveyed by Bloomberg. The ECB meets Jan. 15 to set borrowing costs.

U.S. Outlook

The U.S. economy will grow 1.6 percent in 2010 after contracting 2 percent this year, while the 16-member euro zone shrinks 2.5 percent in 2009 and expands 1 percent the next, according to Deutsche Bank. Treasuries due in 10 years will yield 50 basis points, or 0.5 percentage point, more than comparable German bunds by year-end, instead of about 75 basis points less currently, the bank predicts.

“Like after the Great Depression, the recession in the 1970s and the end of the Cold War, the U.S. will emerge strengthened from this crisis and our competitors won’t,” said Marc Chandler, head of currency strategy at New York-based Brown Brothers Harriman & Co. “Our policies have been very aggressive while the rest of the world has been dragging its feet.”

By year-end, the dollar will trade at $1.30 against the euro and at 100 yen, Chandler said. He predicts it will trade at $1.42 per pound.

The dollar rose to 92.96 yen at 9:16 a.m. in New York, from 91.83 yen on Jan. 2, after earlier reaching 93.57 yen, the highest level since Dec. 8. Against the euro, the dollar climbed 2.3 percent to $1.3611 from $1.3921.

Losing Bet

Selling the dollar in 2008 was a losing bet, as the Dollar Index gained 6 percent to 81.308, its first annual increase since rising 13 percent in 2005. The yen and franc also benefited from investors getting out of risky assets, with Japan’s currency appreciating 19 percent and Switzerland’s strengthening 5.7 percent versus the dollar.

The greenback’s share of foreign reserves rose in the third quarter to 64.6 percent from 63 percent at the end of June, the Washington-based IMF said Dec. 31, the biggest increase since the first three months of 2004.

Investors bought the dollar to purchase Treasuries and shield their money from credit-related losses and stock declines( EXPLICIT GUARANTEES IN A CALLING RUN ) that wiped out more than $28 trillion from equity markets. Writedowns and losses at the world’s largest financial institutions since the start of 2007 total $1 trillion, according to data compiled by Bloomberg.

‘Turning the Economy’

The biggest beneficiary was the yen, as the retreat from risk caused investors to unwind carry trades and buy back the Japanese currency that financed purchases of higher-yielding assets. The search for higher yields may trigger demand for the Australian and New Zealand dollars as money managers take advantage of central bank rates more than 4 percentage points higher than in Japan( TRUE ).

The Australian dollar, which weakened 20 percent against the U.S. dollar last year, depreciated 35 percent in 2008 to 63.67 yen. New Zealand’s dollar fell 39 percent to 52.53 yen.

Emerging markets were among the biggest losers last year as the MSCI EM Index fell 54.5 percent.

“If the governments are successful turning the economy, ironically, that will come along with a very weaker dollar,” said Chirag Gandhi, a money manager of a $2.5 billion global fixed-income fund at the Investment Board of State of Wisconsin in Madison, Wisconsin.

‘Signs of Bottoming’

Developing economies will grow 3.1 percent in 2009, following a 5.9 percent gain last year, while developed countries, including the U.S., the euro area and Japan, will contract 1.4 percent after expanding 0.9 percent in 2008, the Institute of International Finance said in its forecast released Dec. 18 in Washington. The group represents the world’s largest commercial and investment banks.

The currencies of Poland, Brazil and Indonesia will be among the best performers, Bank of America’s Goodman said. The zloty will strengthen to 2.39 per dollar by the end of June after dropping 21 percent. The real will surge to 1.90 after plummeting 30 percent and the rupiah will trade at 10,000 by the end of September, Goodman wrote.

Emerging-market bonds are starting to draw investors( GOOD NEWS ). The extra yield they demand to own the debt instead of Treasuries fell to 6.94 percentage points from 8.62 percentage points in October, according to JPMorgan’s EMBI+ Index.

“If we see some signs of bottoming, then the extreme risk aversion will start to mitigate( I AGREE ),” said Robert Kowit, who manages $3 billion of global bonds at Federated Investors Inc. in Pittsburgh. “At that point, we’ll be left with a huge amount of the dollars that have been printed and a huge amount of debt to be issued and bought.”( VERY TRUE )

We are seeing signs of a diminution in the fear and aversion to risk. How fast will this diminution occur?

"Suddenly risk adverse reserve managers sold what was cheap and bought what was dear, magnifying rather than dampening market moves."

From Brad Setser:

"Central banks aren’t always a stabilizing presence in the market

Posted on Monday, January 5th, 2009

By bsetser

Over the last couple of years it was often asserted that sovereign investors — due to their long time horizons — tend to be a stabilizing presence in markets that they invest in. The argument was generally made about sovereign funds, but it presumably applied at least in part to central banks as well. They have a somewhat shorter time horizon than sovereign fund, but they also presumably care a bit more about financial stability.

Alas, there is now one clear case where an abrupt shift in central bank purchases destabilized a market.

Central banks stopped buying Agency bonds in August and never resumed their purchases. The US Treasury now says that Agency bonds are “effectively” guaranteed — and they certainly have more Treasury backing than in the past. But that wasn’t enough to convince the world’s central banks. They now want nothing less than a full guarantee.( FLIGHT FROM IMPLICIT GUARANTEES TO EXPLICIT GUARANTEES BEGAN BEFORE LEHMAN. FANNIE/FREDDIE? )

The latest (year-end) data from the New York Fed on foreign central banks’ custodial holdings shows that the magnitude of the shift out of Agencies and into Treasuries in the later part of the year. Central banks went from buying $250-300b of Agencies a year (judging from the growth of their FRBNY portfolio) to net sellers of Agencies in a rather short period of time( FLIGHT TO SAFETY ).

The 3 month change in the Fed’s custodial holdings is even more dramatic, and leaves no doubt that central banks have been large set sellers of Agencies. The Fed’s custodial holdings of Treasuries rose by $250 billion over the last three months of 2008 while the Fed’s custodial holdings of Agencies fell by $150 billion. Try annualizing these numbers. In the fourth quarter, central banks were buying Treasuries at a $1 trillion annual pace and selling Agencies at a $600 billion annual pace.

It seems hard to argue against the proposition that a sudden increase in central bank’s risk aversion( EXACTLY. THE FEAR AND AVERSION TO RISK AND ACCOMPANYING FLIGHT TO SAFETY ) has contributed to the distress in a key part of the US market.

Central bank reserve managers’ core concern, of course, isn’t stabilizing the US debt market. It is making sure that they have enough liquid assets to meet their own country’s liquidity needs. It used to also be to make a bit of profit on the country’s– before it swung to making sure that they didn’t take credit losses. The net result, though, was a lot of pressure on the Agency market in the fourth quarter — and a lot of central bank demand for Treasuries just when private demand for Treasuries also soared. Suddenly risk adverse reserve managers sold what was cheap and bought what was dear, magnifying( YES ) rather than dampening market moves.

This experience should also to some way toward settling another debate: are central banks’ purchases and sales big enough to impact prices in large, liquid markets?

Many argued that the Treasury market was so deep and so liquid that it could absorb even large central bank sales without too much trouble. Central banks (net) purchases were large relative to the Treasury’s (net) sales, but they weren’t that large relative to total Treasury market turnover. That led many to argue that if central bank sales ever pushed a bond away from its fundamental value, private buyers would step in — preventing any large move in price.*

The Agency market isn’t a perfect analogue to the Treasury market. But it is quite large — the outstanding stock of Fannie and Freddie bonds (counting Fannie and Freddie guaranteed MBS) is over $5 trillion. Agency issues aren’t quite as homogenous as Treasury issues, but they don’t differ that much from each other either. Both Freddie and Fannie have lots of outstanding bonds in the market — and, at least until recently, the Agency market was also considered to be fairly liquid. It still doesn’t seem to have been able to absorb the big swing in central bank demand.

Agency spreads widened significantly when central banks pulled back (the expansion in the supply of debt with an implicit if not explicit guarantee also played a role …). They only came back in when the Fed indicated it would start buying Agencies …( YES )

And it sure seems like the enormous increase in central bank demand for Treasuries is one — though certainly not the only — reason why Treasury yields are so low right now( YES ). The obvious risk here is that the US government will infer too much from the fact that Treasury yields collapsed even as Treasury issuance soared. The current surge in central bank demand for Treasuries is unlikely to be sustained, if for no other reason than global reserve growth has slowed and central banks have a finite supply of Agencies to sell. I personally think this risk is manageable, as I expect a meaningful rise in US savings (an a fall in investment) will free up domestic funds for the Treasury (or start to flow into the banks, allowed the Fed to scale back its loans to the banks and scale up its Treasury holdings). But it is a risk.

In one key respect though, central banks have remained a stabilizing force: they abandoned the Agency market, not the dollar market. This underscores an important point, one that I wish I had recognized earlier. Central bank reserve managers can influence the US market in two very different ways:

a) By shifting out of one asset and into another asset. Selling Agencies and buying Treasuries for example. Or selling equities to buy Treasuries. ( GOOD POINT )

b) By shifting out of the dollar ( GOOD POINT )

A country like China that is effectively pegged to the dollar can shift the composition of its US portfolio around without putting much pressure on the dollar or its peg. Moving from Agencies to Treasuries is consequently a fairly low cost option for China. Sure, China gives up a bit of yield( FOR AN EXPLICIT GUARANTEE ). But it doesn’t have to abandon its exchange rate regime. It is an option that China can exercise at a low cost to itself.

Moving away from the dollar, by contrast, would require adjustment in China - not just adjustment in the US … and that hasn’t been something that China has been willing to do( THIS I ATTRIBUTE TO SAVER COUNTRY FEAR OF CHANGING THE CURRENT SYSTEM. ).

* The argument could also be made in reverse. If central bank purchases drove a bond’s price up too much, private investors would sell — so the bond’s price (and yield) wouldn’t move away from its “fundamental” value. That led some to argue that central bank purchases couldn’t have much of an impact on say the Treasury market."

The more I look at this post, and compare it to the VIX, it's obvious that the Fannie/Freddie event was key. Somehow, the government's handling of this spooked investors and caused the beginning of the Flight To Safety.

"But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed"

David Merkel on The Aleph Blog with a list:

"1) There are firsts for everything. Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952. America has always been a pro-debt and pro-debtor nation( SPENDER NATION ). It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period. But, the Pilgrims did extinguish the debt. Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity. With the decline in housing values, the fall in the ratio was inevitable. The low ratio puts downward pressure on home prices, because it means that more homes are underwater ( IT STILL HAS A GOOD SIDE ). Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector. Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more( TRUE ).

5) Now these same low yields whack Treasury money funds. How many will close? How many will cut fees? How many will break the buck, and credit negative interest? An unintended consequence of monetary policy. Another unintended consequence reduces liquidity in the repo markets. Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates( WHO KNOWS? ).

6) Brave Ben Bernanke is fighting the Depression. If his theories are right( I AGREE WITH BERNANKE ) (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy ( TRUE ). But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle( TRUE ).

7) Inflation is the lesser evil at this point.( I AGREE ) It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go( TOO MUCH ), and Elizabeth Warren now confirms it for the Treasury. My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.” So it is for the TARP bailout( A HYBRID ). Policy made hastily rarely works. Spend more time, get it right. The market won’t die as you work it out.

9) But will AIG die, or the automakers?

• Sales are slow for assets at AIG. ( THEY WILL BE. BUYERS CAN TAKE THEIR TIME ) (no surprise valuations are crushed, and all likely buyers face lower P/Es and higher debt costs.)
• And who knows where the writeoffs end? As I said long before the failure of AIG, don’t trust the financial statements ( TRUE ). The palce was too complex, and the culture of fear inhibited objective financial reporting.
• GM’s suppliers are seeking cash. Just one of the costs of financial stress.( WOULDN'T YOU )
  
• Suppliers worry over a lack of demand if the automakers fail. They should retool for Japanese and European automakers. ( MAYBE )
  
• From Credit Slips, the important idea is that without a good business plan the automakers are toast anyway. I predict they will be back hat in hand in half a year even with a bailout( THEN WE CAN LET THEM FAIL ).
• A GM bankruptcy would take a long time, and a prepack would not get done before the cash runs out. Maybe, but I would still take it through bankruptcy, with the US Government as the DIP lender. ( THE BAILOUT NEEDS TO BE SEEN AS JUST THAT, BOTH FOR SOCIAL REASONS DEALING WITH PERCEPTIONS OF FINANCIAL TYPES BEING THE ONLY ONES SAVED, AND THE GOVERNMENT GUARANTEES ARE ESSENTIAL TO GETTING OUT OF THIS . THAT'S WHY INVESTORS ARE FLEEING AGENCIES FOR TRASURIES )
  

10) Even VCs are looking at the survivability of their portfolio holdings. Who can survive and become cash-flow positive in a tough environment. Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers. Watch the loan covenants, so that you can get good recoveries in a default. If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults. For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices. Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss. This is a tough time for anyone taking credit risk. That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics. I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers. He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes. ( I'VE BLOGGED ABOUT THIS POST )

16) You can give the banks funds, but you can’t make them lend. Would you lend if you didn’t have a lot of creditworthy borrowers? ( YOU CAN MAKE THEM LEND )

17) The export boom is dead, for now. Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed. Sorry, but the secret to changing the residential real estate market is not lowering interest rates( IT'S A WAY THAT THEY CAN BE SEEN AS HELPING HOME OWNERS ), but writing-off portions of loan balances. Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater. Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?( THAT'S A POSSIBLE SOLUTION )

19) On commercial property, when do you extend on a loan vs foreclosing? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan. More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position. With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now. (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever. Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming ( TRUE ). As the interest rate differentials narrow in real terms, the US Dollar should improve.( TRUE )

But, there are complicating factors. Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates. Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply ( TRUE ).

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies ( TRUE ). For now, put your macroeconomics books on the shelf, because they won’t be useful for some time ( TRUE ).

A good post.

"if they start to view the pound as Europe’s equivalent of an Agency bond …"

Brad Setser on the wild ride of the dollar recently:

"Only a few days ago, so it seems, it took about $1.25 to buy a euro. Now it takes closer to $1.45 (it was more earlier today, but the dollar subsequently rallied). And — as Macro Man notes — the dollar’s move pales relative to the recent slide in the pound. Not so long ago a pound bought 1.5 euros. Now it buys a euro and change. The Anglo-Saxon currencies haven’t had a good two week run.

Both the US and the UK ( 1 ) had housing and finance centric economies. Both have ( 2 ) significant external deficits. And both are ( 3 ) inclined to use monetary and fiscal policy aggressively to combat a downturn.

But with global trade collapsing, the euro’s rise can not be all that comfortable for members of the eurozone. It isn’t clear that any one wants a stronger currency right now ( THIS MEANS THAT THEIR EXPORTS WILL BE MORE EXPENSIVE IN OTHER COUNTRIES, AND THEY DON'T WANT TO LOSE EXPORT BUSINESS DURING AN ECONOMIC DOWNTURN ). Currencies though are relative prices — and can go up or down amid a global contraction. In theory, everyone could ease monetary policy equally without changing the relative value of any currencies ( THIS WOULD KEEP THE DOLLAR HIGHER ). In practice things rarely work out as neatly ( EXACTLY ).

Dr. Krugman, I would assume, hopes that the euro’s rise puts more pressure on Germany to join a coordinated European fiscal stimulus — with good reason. Germany’s export machine relies on global and European demand. That demand is falling (watch Russian imports for example). And if the euro’s rally is sustained, Germany will soon face an additional headwind. So too will the less competitive members of the eurozone. They are in an even more difficult position if Germany doesn’t lead a coordinated European reflation. ( GERMAN EXPORTS WILL BE TOO EXPENSIVE )

Four other thoughts:

1) Until fairly recently, all the European currencies tended to move in tandem against the dollar. That meant their cross-rates were stable. And it meant that the euro wasn’t as strong as it seemed. The euro was strong against the dollar and the yen, but not against the pound, the Swedish krona, the Norwegian krona and similar currencies. Right now the euro is rising against all the smaller European currencies — not just against the dollar.

2) Japan is starting too worry about yen strength, not surprising. Renewed intervention seems like a possibility if the yen continues to rise. That shouldn’t be a surprise. Japan tends to intervene heavily when the interest different between the yen and dollar goes away, reducing private market demand for dollars.

3) China has to be pleased by the euro’s rally. Dollar strength translated into RMB strength — and a rising RMB when Chinese exports were slowing (and likely now falling) made Chinese policy makers uncomfortable. There was even talk of moving to a real basket peg — which would have meant that RMB would depreciate against the dollar when the dollar was strong. But I rather doubt that China now wants to appreciate against the dollar to offset the dollar’s renewed weakness against the euro. Right now China is happy to see the dollar and thus the RMB weaken( THAT WAY THEIR EXPORTS DON'T GET MORE EXPENSIVE FOR US ) …

4) Central banks have been big buyers of the pound over the past few years. Reserves were growing, and the pound’s share was rising. Central banks liked its yield( PAID HIGHER INTEREST ) — and the fact that it an easy alternative to both the dollar and the euro. By my count, central bank inflows often were large enough to cover the UK’s current account deficit. Central banks reserves are shooting up, but if they “rebalance” their portfolios they should be big buyers of pounds now — as they need to hold more pounds to keep the pound’s share of their portfolio up as the pound’s value slides.

I’ll be interested to see if they do so — or if they start to view the pound as Europe’s equivalent of an Agency bond …( AND NOT BUY IT AS TOO RISKY )

Notice the Chinese Contradiction:

1) They don't want the dollar to weaken so that they can export to us

2) That's happening because we're printing money

3) Yet, they tell us not to borrow too much from them, and they don't want to spend too much

Problem: On 3, it has to be one or the other

Either we borrow more and they save more

or

we save more and they spend more

"The dollar's fall, however, is making it far harder for Europe and Japan in particular to export their way out of recession. "

I posted a graph showing the recent rise and decline of the dollar. From the Washington Post:

"By Anthony Faiola

Washington Post Staff Writer
Thursday, December 18, 2008; Page A01

The dollar yesterday staged one of its biggest one-day drops against the euro and fell to a 13-year low against the Japanese yen as near-zero interest rates and the Federal Reserve's plan to print vast sums of cash dilute the value of the greenback.( Quantitative Easing )

The drops dramatically accelerated the dollar's reversal of fortune over the past three weeks after months of solid gains( THE FLIGHT TO SAFETY IN US BONDS ). The slide underscores the risks the Federal Reserve is taking to jump-start the U.S. economy through aggressive monetary policy( THERE ARE RISKS ).

On Monday, the Fed cut its target for the federal funds rate, at which banks lend to each other, from 1 percent to a target range of 0 percent to 0.25 percent, and effectively vowed to print as much money as it needs to try to pull the United States from a worsening recession ( I'M FOR THIS ).

While that policy may ultimately aid an economic recovery, it is robbing the dollar of value as investors anticipate less interest on their dollar-denominated investments and more bills in circulation, making each one worth a bit less. In response, investors are dumping the dollar and buying up other currencies ( I PREFER TO SAY THAT IF THEY BUY BONDS NOW, AND INFLATION ARISES, THEIR BONDS WILL BE WORTH LESS. ON THE OTHER HAND, SINCE THERE WILL BE MORE DOLLARS IN CIRCULATION, THE DOLLARS THEY ARE HOLDING NOW WILL BE WORTH LESS ( FROM QUANTITATIVE EASING ) ).

If the dollar's fall is unchecked, it could jeopardize the long-term faith of foreign investors in the value of the American currency and could cause foreign investors to dump U.S. stocks and other assets, whose value would be worth less in euros or yen( TRUE ). The Dow Jones industrial average fell 1.1 percent yesterday.

A sharp rise in the value of foreign currencies could slow economic recovery in Europe and Japan because it would make their exports more expensive in the United States ( TRUE ). A steep, sustained fall in the dollar could force the Fed to abruptly raise interest rates to prop it up( IN ORDER TO GIVE INVESTORS AN INCENTIVE TO BUY BONDS BECAUSE OF THE HIGHER INTEREST RATES, AND THEIR DOLLARS WOULD GAIN IN VALUE IF THE MONEY SUPPLY CONTRACTS ). That would drive up costs( BECAUSE IT WOULD BE PAYING MORE INTEREST ) for the U.S. Treasury as it seeks to raise cash for bailouts by issuing billions of dollars worth of new debt to investors.

"The risk is that the deceleration of the dollar could cascade, and push interest rates up as the rest of the world demands a higher return on U.S. investments," said C. Fred Bergsten, director of the Peterson Institute for International Economics.

But higher interest rates could weaken demand even more. The deteriorating economic outlook helped send oil prices down yesterday to $40.06 on the New York Mercantile Exchange, despite production cuts by the Organization of the Petroleum Exporting Countries, and the falling dollar, which should help drive up oil prices because they are denominated in dollars( AND SO WORTH LESS ).

The dollar shed about 3 percent against the euro yesterday, falling to $1.44. It lost 1.3 percent against the Japanese yen, dropping to 87.93, the lowest since July 1995.

The slide marks another turn on the dollar's roller coaster year, which it began at multiyear lows when the U.S. economy slowed even as much of the rest of world was still growing. But as investors began to grasp that Europe and Japan were facing recessions as bad, if not worse, than the one in the United States, the dollar staged a rally. Between July and November, the dollar climbed about 24 percent against a basket of six major world currencies( MAINLY THE FLIGHT TO SAFETY ).

The Fed's aggressive interest rate policy ( QUANTITATIVE EASING ), coupled with a sense that the United States may face dire problems in the auto industry( MORE EASING AND DEBT ), have erased about half those gains in the past three weeks. Up until recently, emerging market currencies were also losing ground against the dollar. The Chinese, analysts say, have been massively intervening in currency markets in recent months to weaken( KEEP IT CHEAP ) the yuan and make Chinese exports more competitive overseas( BY STAYING CHEAP ). But the yuan has jumped 0.7 percent against the dollar this month, despite continued Chinese intervention.

That is good news for U.S. exporters ( OUR GOODS ARE CHEAPER ). The cheaper dollar earlier this year had boosted overseas sales of American-made products from airplanes to soybeans, making exports a rare bright spot of the economy. In recent months, however, the export boom has faded as the dollar strengthened and the global economy waned. The suddenly weaker dollar may now help put U.S. exports back on track, just when the economy needs all the help it can get ( THEORETICALLY, EXPORTS SHOULD GO UP WITH A CHEAPER DOLLAR, AND, AT SOME POINT, AS THE ECONOMY DOES BETTER, THE DOLLAR WILL STABILIZE OR TURN AROUND ).

The dollar's fall, however, is making it far harder for Europe and Japan in particular to export their way out of recession ( THEIR GOODS ARE GETTING MORE EXPENSIVE FOR US ).

Japan, which already has near-zero interest rates, has little room to lower them further to weaken the yen. But analysts say Tokyo is likely buy more dollars ( THAT SHOULD STRENGTHEN THE DOLLAR, MAKE THE YEN CHEAPER ) in an attempt to drive the yen down in value.

The dollar's fall is putting particular pressure on the European Central Bank to follow the Federal Reserve and the Bank of Japan and dramatically cut interest rates ( WITH THEIR HIGHER INTEREST RATES AND RETURN, MONEY IS GOING THERE AND NOT TO THE DOLLAR ), according to analysts. The ECB has been reluctant to slash rates too deeply, partly because it fears that inflation will reemerge in major countries like France( THIS SHOULD BE EXPLAINED ) should rates fall too low.

Yet analysts say the weakened dollar may force the ECB to cut rates, fearing the steep climb in the euro could make it far harder for export-driven economies like Germany to stage a recovery. Some in Europe are responding aggressively. The Central Bank in Norway, which does not use the euro, dramatically slashed key interest rates yesterday by 1.75 percent to 3 percent.

"This really puts the Europeans in a corner," said Simon Johnson, former chief economist at the International Monetary Fund and an economist at the Massachusetts Institute of Technology. "They can't just sit there and watch the euro climb( EXPORTS WILL GO DOWN, HURTING THEIR ECONOMY )."

Other analysts argue that the dollar may surge again in the weeks ahead, particularly if the Fed's aggressive moves begin to show signs of lifting the U.S. economy ( IF QUANTITATIVE EASING WORKS ).

"I'm a little skeptical that this is the end of the dollar's rebound," said John Shin, currency strategist at Merrill Lynch in New York. "Investors are reacting to the anticipation and the actuality of the Fed's plan to flood the world with dollars. But the U.S. is not alone in its problems, and you're seeing particular stress on the European economy. You have to think that the Fed is ahead of the curve, and by the time the Europeans get there, the U.S. economy may be better positioned for recovery( OTHER COUNTRIES WILL END UP DOING WHAT WE'RE DOING, GIVING THEM NO COMPETITIVE ADVANTAGE WITH HIGHER INTEREST RATES, GIVING THE DOLLAR STRENGTH AGAINST THE OTHER CURRENCIES )."

The Dollar's steep rise was the Flight To Safety, the steep decline is Fear Of Inflation. Both are likely overreactions to actual conditions. I hope.

"At least a crisis marked by a run out of risky US assets and into safe US assets. "

Brad Setser looks at Balance Of Payment Data:

At least a crisis marked by a run out of risky US assets and into safe US assets (THE FLIGHT TO SAFETY ). Right now Agency bonds — think Freddie and Fannie — are considered risky assets while Treasuries are not ( WHY ? BECAUSE THEY ARE EXPLICITLY GUARANTEED BY THE GOVERNMENT I PRESUME, WHILE THE AGENCY BONDS ARE IMPLICITLY GUARANTEED. TO ME, THIS UNCERTAINTY SPRINGS MAINLY FROM LEHMAN. I AM ALONE IN BELIEVING THIS APPARENTLY )

A run out of all US assets and the dollar would look very different.

The October TIC data tells a striking story — one marked by a massive surge in demand by both private and official investors for “safe” assets. Foreign investors bought $182 billion of Treasuries — including $147.4 billion of short-term Treasury bills. There is no real mystery why bill yields dropped so low even as the supply of bills surged. And foreigners added $207 billion to dollar bank accounts.

Sum that up and it works out to close to $400 billion in demand for safe dollar denominated assets. If that kind of monthly inflow is annualized it is a shockingly large number. ( THAT'S A MEASURE OF THE FEAR AND AVERSION TO RISK AND ACCOMPANYING FLIGHT TO SAFETY )

It isn’t hard to figure out why the dollar rallied.

$400 billion in a month is far more than the US needs to cover its trade deficit. It allowed foreigners to reduce their holdings of Agencies by close to $75 billion (including a $25 billion fall in short-term Agencies), their holdings of long-term corporate bonds by $13 billion and their holdings of US equities by $6 billion without causing any strain on the dollar.

Indeed, the fall in foreign holdings of US corporate bonds and US equities (though not the outflow from the Agencies) could have been financed by the sale of $36 billion of foreign assets by US residents …

Usually I argue that the TIC data understates official flows. And this month’s data may well do so.

Some of the $35 billion in long-term Treasury bonds bought by UK investors were probably bought by central banks, and selling by central banks could have contributed to the $13.8b in net sales of long-term Agencies. But in broad terms I don’t doubt that private demand for “safe” US assets soared as a result of the crisis — and much of the inflow came from private investors seeking to increase their holdings of the most liquid dollar assets ( LIQUIDITY IS ALSO IMPORTANT AS A RESULT OF THIS CRISIS ).

In October, China was about the only central bank adding to its reserves (I suspect, it hasn’t formally released its reserves data). Most central banks were selling. That shows up in the US TIC data. South Korea, Brazil, Mexico, Russia and Ukraine were all net sellers of long-term US Treasury bonds …

The big central bank flow was a reallocation away from Agencies toward Treasuries. And specifically toward short-term Treasury bills.

China increased its holdings of short-term Treasury bills by a stunning $56 billion while also buying $10 billion of long-term Treasuries. That flow alone would have been enough to cover the trade deficit in the absence of any offsetting outflows. Russia cut its holdings of short-term Agencies by a little over $22 billion while increasing its holdings of short-term Treasuries by almost $12 billion.

So much for talk that central banks are always a stabilizing presence the market. They clearly have destabilized the Agency market. The fall in demand for Agencies over the past three months — and most Agency demand has come from central banks until recently — has been sharper than than the fall in demand for US corporate bonds (think securitized subprime mortgages, the category “corporate bonds” in the BoP data includes asset-backed securities) after the crisis of last August.

The fall in demand for corporate bonds (the redline) is what generated a rather scary graph after the initial crisis last August. Things haven’t gotten any better since …

The Agency market is a rather important market. Increased lending by the Agencies offset the fall in demand for “private” mortgage-backed securities after the crisis last August. More recently, the absence of a “central bank bid” has kept Agency spreads wide even after the US Treasury bailout of Freddie and Fannie. And that in turn has pushed the US to adopt other measures to bring down long-term mortgage rates. The Fed and the Treasury are literally now buying the Agencies that foreign central banks are selling. Action, reaction …"

"The US Dollar index fell another 2.2% today for its biggest 6-day decline ever."

Bespoke has a graph that's hard to believe, unless you believe that the dollar's recent strength was due to the Flight To Safety, which has made just about every chart hard to believe:

"Biggest 6-Day Decline For The Dollar Ever

The US Dollar index fell another 2.2% today for its biggest 6-day decline ever. As shown in the table below, the current 6-day decline of 8.07% tops the prior record decline of -7.48% set back in September of 1985. If it's not one asset falling these days, there's sure to be another.

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"In any case, the Fed’s move pushes us in the definite direction of higher global inflation. "

Simon Johnson is a member of the "Helicopter Club" on The Baseline Scenario":

"The Federal Reserve’s announcement yesterday makes it clear that we should see its leadership as radical incrementalists ( PRAGMATISTS ). They will move in distinct incremental steps, some small and some larger, but they will do whatever it takes to prevent deflation ( KITCHEN SINK ). And that means they will do what it takes to make sure that inflation remains (or goes back to being?) positive ( DEBASE THE CURRENCY ). If they need to err on the side of slightly higher inflation, then so be it. This is pretty radical (and a good idea, in my opinion.) ( SIR, I AM NOT A RADICAL )

What effect does this have on the rest of the world? Well, if your central bank now sits idly by, most likely you will experience an appreciation of your currency relative to the US dollar. (The caveat, of course, is that if you have a new major domestic disruption in your banks, or another member of your currency union runs into refinancing trouble, you could still experience a depreciation.)

Who is willing to experience a significant appreciation in a slowing global economy, with exporters everywhere already clamoring for assistance? Most central banks will be pressed hard to ease further, either with interest rate cuts or their own version of “quantitative easing” (known as printing money to you and me) ( THAT'S WHAT THEY SHOULD DO ). What happens within the eurozone will, in this context, be fascinating - who will support the Germans in arguing that monetary policy should remain relatively tight? ( DON'T GET ME STARTED ON GERMANY ) What happens if the Germans lose this argument at the level of the European Central Bank’s Governing Council? ( I BELIEVE THAT'S WHAT WE WANT )

In any case, the Fed’s move pushes us in the definite direction of higher global inflation. This is better than the alternative of falling wages and prices, but it comes with risks ( AGREED ). Will we be able to control this inflation now or in the near future? ( A ROUGH RIDE AHEAD. BUCKLE UP ) What are the consequences of inflation during a severe global recession - which seems unavoidable, even if the Obama Administration has all possible dimensions of expansionary policy firing on all cyclinders right away ( BLASTOFF! ) (this was the point in our latest baseline scenario)."

I've already said that, for this to truly work well, other countries should debase the currency as well, although how much will vary for each country as we go along.

Here's a clip from a movie that contains my favorite use of the word "Blastoff!". By the way, Slim Pickens is from my home town:

"Dollar/Oil Reversal": Correlative Reasoning?

Here's an interesting comparison of charts on Bespoke. Correlative Reasoning anyone?:

"From a technical perspective, the US Dollar index is not looking good, while oil has just broken above one of its downtrend lines. While the Dollar hasn't broken its uptrend from its July lows yet, it's getting very close, and the action of the currency over the next couple of days should provide insight into how it will trade over the next few months. If it can hold support, it will remain in bull market mode, but if it breaks its uptrend line, look out below. Oil, on the other hand, finally looks to have at least stabilized from its epic freefall since its July highs. While it has a long, long way to go before putting a dent in its losses, its recent break above its short-term downtrend line is a start.

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"The risk that this is not the relevant analogy for the US, and that policymakers are not prepared to accept such a possibility."

After saying that mining the Great Depression for clues on how to get us out of this current problem is of minimal use, I find this post by Tim Duy on the Economist's View interesting:

"But to be a real Dollar rout, we would expect to see Treasuries come under severe pressure, which has not exactly been a recent trend. So perhaps there really is nothing to fear. Indeed, I have argued that that if the stimulus is too excessive, that excess should reveal itself in the Treasury market, and policymakers can simply back off. No problem – ease away. Build those bridges.

This assumes that policymakers back off. What if rising Treasury rates encourage the Fed to double down, expanding quantitative easing to hold rates low and stimulative. What if years of research on the Great Depression have left even the best and the brightest with tunnel vision such that they could not accept that they were wrong?

Bottom Line: The Fed is headed to the zero mark, with another 50bp almost certain this week. It is widely expected that they will give some guidance as to their next steps, pointing us in the direction of an explicit policy of quantitative easing. Fed policy, as well as fiscal policy, assumes that the Great Depression is the most accurate analogy. This assumption ignores the external position of the US, which stubbornly refuses to adjust. If that failure to adjust is relevant, then recent Dollar stability was simply a head-fake. We should see pressure on the Dollar and, ultimately, Treasuries. Policymakers could adjust, but would they? With pursuit of the Great Depression case as the baseline scenario, it seems prudent to keep in mind the risk that this is not the relevant analogy for the US, and that policymakers are not prepared to accept such a possibility."

I think that Printing Money is simply the clearest option that we have. It has little to do with the Great Depression. The problems this could lead to are serious, and we'll be in for a rough ride. But the fact that the policy of Printing Money is Assessable makes it a good choice. I doubt that anyone in this mess is going to hold to a failing policy for too long. Rather, I would fear that we do not give these policies a chance to be assessed.

As to the point about the usefulness of the Analogy with the Great Depression, I agree.

"Was the negative yield on the three month T-Bill a wake up call to foreign investors that holding cash in Dollars is not a very attractive option?"

I mentioned Dollar's Decline earlier, here's a chart from Bespoke:

"While investors have been focused on the S&P 500 and its attempt to break through its 50-day moving average, the Dollar had no problems breaking through its 50-day. Unfortunately, the break was to the downside. With a decline of 1.5% today, the US Dollar index traded below its 50-day moving average for the first time since late July. At the same time the Dollar has been falling, the Euro has been rallying, as it broke above its 50-day moving average for the first time in months. Was the negative yield on the three month T-Bill a wake up call to foreign investors that holding cash in Dollars is not a very attractive option?

Not surprisingly, Gold is benefiting from the Dollar's weakness with a gain of 3% today. A look at this chart shows that the commodity is still nowhere near breaking its downtrend. However, it is currently trading right at a short-term resistance level of around $830. How it acts in the weeks and months ahead will be a good indication of how concerned the market is regarding inflation.

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"The dollar doesn’t have to go south if all the economies reflate at the same time.”

I like William Gross, so here's a chance to quote him from Bloomberg:

"By Ye Xie

Dec. 11 (Bloomberg) -- The dollar fell to a six-week low against the euro and yen as the cost of borrowing in the U.S. currency tumbled, signaling less demand for year-end funding.

The greenback also dropped after a report showed the U.S. trade deficit unexpectedly widened in October. The Swiss franc dropped against the euro and yen after the central bank reduced its main interest rate to a four-year low of 0.5 percent.

“Dollar liquidity and funding concerns are starting to fade,” said Shaun Osborne, chief currency strategist in Toronto at TD Securities Inc., a unit of Canada’s second largest bank. “These factors have been important sources of support for the dollar in the past few months.”

The U.S. currency fell 1.7 percent to $1.3243 per euro at 8:40 a.m. in New York, from $1.3023 yesterday. It dropped 1.6 percent to 91.28 yen from 92.76. The euro traded at 120.77 yen, compared with 120.78 yen.

The cost of borrowing in dollars for three months in London fell to the lowest level in more than four years. The London interbank offered rate, or Libor, that banks say they charge each other for such loans slid 0.1 percentage point to 2 percent, the lowest level since September 2004, British Bankers’ Association data showed. That’s still one percentage point above the Fed target, up from an average of 16 basis points in the seven years to August 2007, when the credit freeze began.

“From a fundamental basis, there’s a case for avoiding the dollar,” said Adrian Schmidt, a London-based senior foreign- exchange strategist at the Royal Bank of Scotland Plc, the fourth-biggest currency trader. “For the moment the dollar’s on the back foot.”

How interesting.

"The ICE’s Dollar Index, which tracks the greenback against the euro, the yen, the pound, the Canadian dollar, the Swiss franc and Sweden’s krona, fell 1.2 percent at 84.449, below the 55-moving-day average of 84.5, as traders took advantage of the low liquidity to test how far it may fall, Hardman said. They will drive the dollar to $1.345 per euro this year, he said.

The dollar has gained 11 percent against the euro in 2008 as the credit-market seizure and $980 billion of losses on mortgage-related securities worldwide led investors to repatriate overseas investments to the U.S. and seek funding in the greenback.

The yen gained versus all 178 currencies tracked by Bloomberg this year as the global recession encouraged Japanese investors to bring funds back home and global equities plunged.

Japan’s currency jumped 21 percent versus the dollar, 34 percent against the euro and 66 percent against Brazil’s real as the financial crisis prompted investors to reverse carry trades, in which they purchase higher-yielding assets funded in countries where borrowing costs are lower. Japan’s benchmark rate of 0.3 percent is the lowest among major economies.

The U.S. trade deficit expanded 1.1 percent to $57.2 billion in October from a revised $56.6 billion in September, the Commerce Department said today in Washington. The gap was projected to narrow to $53.5 billion from an initially reported $56.5 billion in September, according to the median forecast in a Bloomberg News survey of 70 economists.

The U.S. budget deficit in November swelled to $164.4 billion, from $98.2 billion in the year-earlier period, as the government used taxpayer money to shore up the financial system by buying stakes in banks, the Treasury Department reported yesterday. Government revenue fell 4.2 percent, while spending soared 24 percent."

Let's see what Gross says:

"The dollar may extend its decline as the U.S. government increases its budget deficit by spending “trillions of dollars” to revive the economy, said Bill Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co. in Newport Beach, California.

“There’s some risk” for the dollar to weaken, Gross said in an interview on Bloomberg Television yesterday. “It is fair to say other economies are doing much the same thing. The dollar doesn’t have to go south if all the economies reflate at the same time.”

Let's hope for "reflation" ( Another term. Yikes. ) , I suppose.

"After all, how can a near meltdown of the world’s financial system result in gold falling and the dollar going up? "

Jesse's Cafe Americain quotes Across The Curve and adds a couple charts:

From Across the Curve:

T Bills
December 4th, 2008 11:42 am

I just spoke to a bill trader who noted that a large chunk of the bill list is trading at zero percent. He mentioned a point that I had forgotten but is worth noting. Bills always trade well in December because at year end there is demand for them as investors of every ilk dress up their balance sheets. He has seen that demand to a far greater extent than normal.

He says that given all that has transpired this year there will be enormous demand for bill through the entire month of December. He has seen demand from an eclectic group of investors from around the globe. He expects the treasury to announce shortly a series of cash management bills which would total about $100 billion.

In his opinion if they do not issue bills will scream through zero.

So get used to these low rates they are here for a while.

Let's revisit the current situation.



The comparisons are not quite focused with today in terms of bills and bonds, since the funding preferences of Treasury are different now than they were back then, but you get the general idea of 'Treasuries' and their role in a flight to safety in a portfolio allocation.



But check this post out from Trader's Narrative:

"The mad rush into US government treasury bonds has pushed their yields to never before imagined levels. But according to the simple 1 year rate of change, we may be close or have already seen the end of this “bubble”, as this long term chart shows:

Although I think the bond market

will return to its senses soon enough, US government bonds are not in a real “bubble”. But the extra-ordinary demand for US treasury bonds is at least partially responsible for the strength of the US dollar. Which I’m sure itself is surprising and confounding the gold bugs more than anyone else. After all, how can a near meltdown of the world’s financial system result in gold falling and the dollar going up? Isn’t that the exact opposite of what a sane person would expect to happen?

This recent chapter in financial history is chock full of unprecedented extremes and “Black Swans“. Among them, the yield inversion between equities and treasury bonds (Bloomberg):

Something that we haven’t seen in 50 years. And something that was just as jarring when it was witnessed in 1958. The sharp drop in rates is half the explanation, the other half is the dramatic rise in stock dividend yields."

You know my position. I believe that interest rates are going up, because this downward drive has been based, not on fundamentals, but an overblown aversion and fear of risk, and an accompanying flight to safety. That's also why I think that printing money will work.

"and encouraged investment in interest-sensitive sectors not exposed to Chinese competition (think homes)"

Brad Setser's new post has two interesting statements to me:

"In some sense though it doesn’t really matter now that the Treasury has indicated it won’t allow systemically important financial institutions to fail: in both cases though the ultimate guarantor against losses is the US Treasury."

Great to know.

"You could argue that SAFE and the Fed have combined forces to keep the US economy afloat over the past year. SAFE financed the lion’s share of the United States external deficit – and did most of the heavy lifting earlier in the year when private investors didn’t like the dollar. The Fed’s financing has kept the US financial sector afloat. That incidentally is something that financial sector executives might want to consider as they award bonuses; many financial firms would have failed and not been able to pay anything absent taxpayer support –

On the other hand I would argue that the US shouldn’t give to much credit to SAFE for helping to stabilize the dollar earlier in the year – and for providing the US subsidized financing that has helped keep US borrowing rates fairly low. Why – because a lot of the vulnerabilities that built up in the US economy between 2003 and 2007 can be linked – in part – to large purchases of dollars by SAFE during that period. Holding the RMB down discouraged investment in the US tradable sector, and encouraged investment in interest-sensitive sectors not exposed to Chinese competition (think homes). And the rise in China’s surplus even as the oil exporters surplus was growing implied large offsetting deficits in the US and Europe. In practice that meant that Chinese demand for US assets — with more than a bit of help from US and European banks and shadow banks — supported the low level of savings and high level of borrowing in the US household sector."

I know that it might have made the low level of savings and high level of borrowing possible, but did it make it inevitable. I'm beginning to feel that it's either the products or conditions, and not the actors, who are responsible for this mess. I just don't believe it.

Here's my comment:

November 1st, 2008 at 10:16 pm
1. Don the libertarian Democrat responds:
   

   “In practice that meant that Chinese demand for US assets — with more than a bit of help from US and European banks and shadow banks — supported the low level of savings and high level of borrowing in the US household sector.”

   It’s one thing to make something possible, another to make it inevitable. Is there any place for human agency in these crises?

   Either money is too tempting, or the products are too complex. I just don’t buy it. But then, I’m no expert, just someone trying to understand how these decisions get made.