It's been almost two months since I wrote my last MPPI email at Lehman Brothers, and I figured it was about time I started writing them again, although they will be less frequent and minus the MPPI but I thought I'd keep the name for old-times sake. Anyway, back to financial markets...
Much has been made recently around hedge fund deleveraging and repatriation flows driving the USD up against pretty much every currency apart from the Yen. Certainly, there is probably more of this to go on into the end of the year and the spring as redemption requests and the general degearing of the financial system continues. But these flows have been masking something far more serious: the inability of the banking system to intermediate the Current Account deficit.
Many commentators have compared the current crisis with both the Great Depression and the Japanese Banking Crisis. Certainly, there are similarities, but there are also significant differences, and in my opinion, the most important is that the US runs a significant Current Account deficit. This effectively means that the US requires overseas creditors to purchase the unsecured debt of the banking system (household consumption is financed by banks) otherwise a Current Account adjustment must take place involving a fall in the currency and rebalancing of the economy away from consumption.
The US Government has embarked on a series of haphazard policy responses that have left overseas investors unsure of how they will react to future crises. The two most obvious examples are the allowal of the failure of Lehman Brothers (of course, I'm biased here!) which left senior bond-holders with just 8c on the Dollar and the confiscation of Washington Mutual Bank leaving the holding company and thus senior bond-holders with nothing. The first action completely shut the credit markets, leaving the Federal Reserve to be a substitute for the CP market, and introduced settlement risk at the worst possible moment for the financial system. The second action (as discussed in an outstanding blog post by John Hempton: http://brontecapital.blogspot.com/2008/11/why-sheila-bair-must-resign.html) was essentially the theft of a significant amount of money that WaMu bondholders could reasonably have expected to receive if the company was liquidated.
The confiscation of assets and inconsistencies of policymakers throughout this crisis have arguably contributed to its severity in removing the trust of overseas creditors - the first example of this was the move out of Agencies and into USTs from mid-July (at the time of the original GSE bail-out) - and looks more like Japanese policymaking of the 1990s than that of the Washington Consensus. The complete freeze of the debt markets for bank debt as a result of the above forced the introduction of FDIC-guaranteed bank debt that has found a market. But this is equivalent to the US Government attempting to intermediate the Current Account deficit. Hank and Sheila are playing a very dangerous game with the US's ability to finance itself.
Bernanke has mentioned that the Fed could buy up Treasuries, MBS and other assets, and the examples of Japan and the Great Depression have been used to argue that this will not result in inflation. But this neglects to consider the above points with respect to the US's reliance on overseas credit and the views of those creditors with respect to the effect of Quantatitve Easing upon thier USD-denominated assets. It also assumes that they will continue to provide an incredibly large amount of financing. And there are plenty of countries with exceptionally large budget deficits all ramping up issuance of debt.
On top of this, the recent (in)action by the PBOC in allowing the Yuan to weaken modestly, at a time when trade policy is about to turn more protectionist in the US, highlights just how vulnerable the US is to China reducing its purchases of Treasuries (or even outright selling). So in short, I don't like the Dollar one bit, and as these deleveraging flows slow down it could come under a lot of pressure. Along with the Pound (which is already taking a fair battering) as the UK attempts to do the same as the US but without an obvious market for its outrageous borrowing requirement and without an obvious source of tax revenues to pay for it all in the future and without the revered status of "reserve currency".
Finally, UK Treasury 5yr CDS hit 104bp yesterday, making the UK Government less credit-worthy than Cadbury's (maker of the Wispa chocolate bar) who's 5yr CDS is sat at 85bp. Does anyone want to make a market on the number of months until we have to go to the IMF?
