An End-of-Quarter Dollar Rally in Face of Bailout Drama

It is the end of the third quarter, and demand for US dollars has been exceptionally strong. This is related to repatriation flows and profit taking following yesterday’s big moves. The stock market closed up 488 points, which is approximately 60 percent of Monday’s historic sell-off.

On the bailout front, since Congress is on recess for the Jewish holidays, there have been no significant developments. As a result, to credit today’s rally on the hope for a new bailout plan may be a bit of a stretch since the Senators haven’t even sat down to discuss potential changes. Therefore we still believe that yesterday’s sell-off is the market’s true sentiment towards the US dollar and US stocks and, so far, there aren’t any concrete reasons to believe otherwise.

How Higher LIBOR Rates Impact Average Americans

Despite today’s recovery, there is evidence that investors and banks are still nervous. The overnight LIBOR rate, which is the rate at which banks lend to each other, hit an all-time high of 6.88 percent intraday. The 3 month LIBOR rate is also above 4 percent, the highest level since January. For the average American, overnight lending rates or the 3 month LIBOR have little significance until they realize that many home equity loans, lines of credit, student loans, small business loans and credit card rates uses LIBOR as an index. Therefore the rise in borrowing costs will surely be felt on Main Street as lenders charge higher interest rates on loans. For the average American, this adds further strain to their ever-thinning pocketbooks.

Lending between banks is frozen as counterparty risk remains the number one problem in the financial markets. Volatility continues to remain high and we do not see any reason for that to change either. Yesterday, the S&P500 fell by the largest amount in 20 years and today, the index came close to rising by the most in 6 years. This schizophrenic behavior of the markets is sure to turn many investors gunshy.

Will An Interest Rate Cut Help?

In order to restore confidence at this stage of the game, the Bush Administration needs to shock the markets. One way of doing so could be through a rate cut by the Federal Reserve. As one of the most powerful psychological tools in the government’s arsenal, Bernanke may want to save it until there is evidence that the new bailout plan has failed to stabilize the markets. Fed fund futures have already priced in a quarter point rate cut between now and the October 29 monetary policy meeting.

However, the futures contracts have been wrong in the past, and should the new bailout package prove to be stronger than the one proposed on Monday, the futures contracts will price in a smaller chance of a rate cut. For the Federal Reserve, after pumping a huge amount of liquidity into the financial system, inflation has become a very big concern. Therefore Bernanke will not readily agree to cut interest rates unless he has no other choice. Furthermore, a measly 25bp rate cut from the Fed may not do the trick. Risk aversion is so severe that the only things that can stabilize the markets may be a 50bp one-shot rate cut or a coordinated easing by central banks around the world, but Bernanke will have a tough time convincing his Eurozone counterpart, Trichet.

Raising the FDIC Limit

In the latest development of the bailout drama, the most popular and likely proposal is to raise the FDIC insurance from $100,000 to $250,000. This bribe to Main Street offers a jolt of confidence and peace of mind. For the government no initial outlay is needed to increase the FDIC limit. As I wrote earlier, the three big banks that are left on Wall Street - Bank of America (BAC), JPMorgan Chase (JPM) and Citigroup (C) will still be here when the dust settles. According to today’s WSJ, the Big 3 holds approximately 75 percent of all US deposits. Therefore even if other commercial banks fail, the FDIC only has to fork over a limited amount of money and even if they have to fork out more than that, it is the confidence booster that Americans need.

Consumer Confidence Improves but Still Near 16 Year Lows

Interestingly enough, despite the problems in the US financial markets, consumer confidence actually improved in the month of September from 58.5 to 59.8. However, the index still remains near its 16-year lows and is half of what it was a year ago. It is important to note that the survey was closed on September 23, which was before the 777-point slide in the Dow on Monday. The Chicago PMI index also beat expectations even though manufacturing activity in the Chicago region slowed this month. There were no silver linings in the house price report, which dropped 16.3 percent in the month of July, the fastest pace on record.

On Wednesday we are expecting our first leading indicators for Friday’s non-farm payrolls report. This includes the ADP employment change, the Challenger layoffs report, and manufacturing ISM. The numbers will shed more light on the weakness of the US labor market.

Comments

[User 265729:]

Raising the FDIC limit? Ms. Lien, as it stands right now the U.S. Government has the ability (actual funds) to pay one dollar for every hundred dollars of insured assets under the FDIC. In other words, if there was a run on a couple of major banks tomorrow, the FDIC would be against the wall. So they raise it tomorrow to $500,000.00/deposit -- the FDIC has the funds to 20 cents.

Just like Social Security, the U.S. Government has robbed Peter to pay Paul. Things are started to hit the fan and Paulson and Bush are rushing to get in front of a train speeding off a cliff.

2008 Sep 30 08:22 PM

[Muzie:]

"To stabilize the market, the Fed must shock the markets." Did you actually read yourself.

Please, dear God, no more "stabilization". Can't take more of these 5% swings that in the end finish up with 2% weekly losses.

Message to Fed: "Just Keep The F*** Out."

2008 Sep 30 08:33 PM

[User 265729:]

Muzie, Blunt, but true. Interesting how Bush, Paulson, Pelosi, Frank and Dodd have done more to terrorize the markets than they have to try to provide confidence.

My friend in Europe informed me this evening that the reason that Bush-Paulson are under pressure is that we have DEFAULTED on several loans and we are set to default on some more. The deal they had with the G-7 is that they would deliver a YES vote on the package by Sunday/Monday at the latest and it would be washed under the rug. When the bill failed, the G-7 and everybody under the sun that we owe money to came out of the woodwork. Even Australia..

If you have some time, check out what world leaders and foreign ministers are saying about the U.S.A... They are using terms like we "had better" pass the bill this week, or else.

Why didn't these clowns, especially Bush and Paulson tell us that we've defaulted/will default on loans from foreign governments. No wonder Paulson was trying to sell off some of these broken firms to places like Korea... We OWE them big time and they OWN us! It would have been more honest of them to approach things like that...

Bush should just come out and level with the American people that we owe big bucks to foreign countries and we'd better pay-up. Or else...

2008 Sep 30 08:44 PM

[Lou Thomas:]

It is important to remember that the fed sets a *target* rate for lending between banks, presently at 2 percent, that captures all of the public attention, but this rate must be supported by open market operations that inject liquidity in order to cause the *effective* rate of lending approximately match that target.

Lately, while the target rate has remained at 2 percent, the effective rate has swung wildly as high as 7 percent and as low as about 1.3 percent. So, while public perception may be that the rate is at 2 percent, the effective rate is the result of the Fed's actual policies, as well as market conditions, including the overall reluctance that banks have to lend to one another.

The Fed fund futures mentioned in the article are settled at the effective rate, not the much more visible target rate, and so that is probably one of the main reasons that they do not accurately predict what the Fed is going to announce publicly as its target.

It occurs to me that since the dollar is extremely vulnerable, the Fed may not want to cut the visible rate, but may still be undertaking policies that attempt to lower it below the public target of 2 percent. I say attempt because in the current environment, dominated, as the article notes, by counterparty risk, this may not always be possible. Hence, the wild fluctuations in the effective rate, which usually follows the target fairly closely.

Since a rate cut must be supported by open market operations to inject liquidity sufficient to cause banks to lend to one another at the lower rate, and since the Fed has already swapped a great deal (all?) of its original 900 billion of good stuff for junk collateral, one has to wonder whether the Fed actually has the wherewithal to support a lower effective rate, but so far they are below the target at least some of the time. Didn't the treasury have to do a special bond issue to back $40 billion of the AIG bailout? That may have been the point that the Fed's assets were (at least temporarily) exhausted.

Regarding the LIBOR, while home equity loans were mentioned, the larger problem would seem to be ARMs, which are generally tied to the LIBOR. The ARMs are in the pipeline fully ARMed and waiting to explode in the coming months. If those adjustable rates are adjusted way higher due to LIBOR increases, it will make the calamity just that much worse.

Overall, a reasonable and well-considered article, IMHO.

2008 Sep 30 09:50 PM

[captainjohann:]

How much India is being suckered into this?Manmohan is ex/worldbank?

2008 Oct 01 08:37 AM

[Britishsteel:]

people vote against this bailout or you will be reduced to poverty not seen since the great depression, this was on kudlow tonite: 9/30/08

"Paulson and Bush threatened to veto the legislation if there was an explicit prohibition of transfers from foreign banks to an American subsidiary."

THE ASSETS DO NOT EVEN HAVE TO BE AMERICAN MORTGAGE ASSETS - THEY CAN BE AN OFFICE TOWER IN SHANGHAI!

YOU ARE GOING TO GET FLEECED FOR HUNDREDS OF BILLIONS OF DOLLARS IF THIS BILL PASSES - THAT MONEY IS GOING TO GO IMMEDIATELY OUT OF THE COUNTRY!




SEC. 112. COORDINATION WITH FOREIGN AUTHORITIES AND CENTRAL BANKS.

The Secretary shall coordinate, as appropriate, with foreign financial authorities and central banks to work toward the establishment of similar programs by such authorities and central banks. To the extent that such foreign financial authorities or banks hold troubled assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such troubled assets qualify for purchase under section 101.


votenobailout.org/

2008 Oct 01 08:45 AM

[carey_jim:]

When world capitalism is teetering on the brink, by its own admission, all the chickens flock home to the chicken coop in America.

The fundamentals for the dollar are still weak and the basic fundamental is that American manufacturing has gone off shore and the only way it can be brought back is to make the dollar substantially weaker, speaking in free market terms.

But if world capitalism perceives that the the center, America itself, is in free fall, it might be that it will bet that America will try to arrange a bailout for the dollar itself, in the form of a new Bretton Woods treaty.

A strong dollar would completely destroy our manufacturing base, of course.

2008 Oct 01 11:13 AM

[NOWHEREMAN:]

MS Lien: I read the above article and am quite impressed with your progress. Short and concise, it allows readers to make their own opinion out of the facts presented.

I have avoided your articles in the past but the Title caught my eye, so here I am and I am grateful that I took another chance.

LIBOR will toss a monkey wrench between the Wheels regardless of the present outcome. It will be the next shoe to drop.Long Term Mortgage rates are not a problem. The ongoing short term squeezing that LIBOR presents is destroying the purchasing power of the consumer but no one seems to give more than passing scrutiny to it.

50 basis points will not alleviate this, 100 would certainly help, but at this point to bring LIBOR down to where it should be would be to bring the discount rate to Japans' level.

2008 Oct 01 11:32 AM

[specks:]

The dollar rally is the beginning of a multi-year bull market for the currency. Foreign central banks will raise causing a flight to the US $. Bull market in gold is DONE !!

2008 Oct 01 03:44 PM