Bailout Drama Driving Euro Down

It is the beginning of the fourth quarter and demand for US Dollars continues to be voracious, driving the EUR/USD below 1.40. In less than 2 weeks, the most liquid currency pair in the world has fallen close to 6 percent or more than 8.5 cents (850 pips).

However the dollar is not strong against everything. I have argued that in this current environment, the Japanese Yen should be the best performing currency. Therefore I expect the dollar to weaken against the Yen especially as the Dow continues to tumble. Against the Euro and British pound on the other hand, the dollar is a completely different animal.

Here is a chart of the correlation between the EUR/USD and Oil Prices for information purposes

Take Two of Bailout Drama

Although there are many reasons to explain the dollar’s recent strength against the Euro, the latest wave of buying has been triggered by take two of the bailout drama. The Senate is slated to vote on a new $700 billion bailout plan that includes an increase in the FDIC insurance cap from $100,000 to $250,000 this evening and then it's off to House for approval. Politically, it would be damaging to both the Democrats and Republicans if the second attempt does not pass. Adding to the Euro’s weakness and the dollar’s strength were hawkish comments from Fed President Plosser and the stronger ADP employment numbers. Plosser, who is usually more hawkish than his counterparts said that he is skeptical about a rate cut even though the market has completely priced in a 25bp rate cut for October.

Don’t Believe ADP

As for the ADP, unfortunately I do not think there is any truth to the numbers especially since the report only captures the first 2 weeks of September. This would not be the first time that the ADP has overestimated non-farm payrolls. There is no question that the US economy remains weak and the big drop in the manufacturing ISM index confirms that. The index fell to the lowest level since October 2001 but what I find more interesting is the fact that the employment index dropped significantly as well.

Premature for ECB to Cut Rates

Trouble also continues to brew in Europe. There is talk that EU leaders could be discussing a TARP-like plan for the Eurozone. Whether this passes remains to be seen, but it does tell us that European leaders are worried that more banks could collapse.

The bottom line is that the situation in Europe is not much better which is why the EUR/USD has tumbled. With that in mind however, the ECB still believes that cutting interest rates is premature. At best, Trichet’s tone could be slightly more dovish at tomorrow’s ECB meeting.

Comments

[phdinsuntan...:]

agree on the yen, but the swiss franc can outperform as a safe haven too

2008 Oct 02 09:00 AM

[NOWHEREMAN:]

Take the total number of different Banks in the EU, multiply that total by 100 and you have the US. The EU has raised capital on an ongoing basis and can contain its internal problems, the US has hidden it losses and now are being forced to admit that they can be "marked to market".

The crisis has hit all of them at the same time because they tried to hide the discounted values from the start. Once Merrill Lynch sold some $30 Billion at 22 cents on the dollar, Tier 3 assets were finally quantified to a degree. The big rock was turned over and all of the cockroaches scattered trying to make deals.

Investment Banks lost the ability to fund the deals which were the basis of their earnings, Hedge Funds lost their edge when their access to capital was first squeezed and then hamstrung when margins continued to rise and Governments shortcircuited what used to be normal market activity by first suspending short sales on the weakest stocks and then making announcements on days they knew would cause the most short covering. Because the number of Hedge Funds had grown to equal or surpass the number of Mutual Funds, their investments caused massive overlaps. Redemptions which would not have caused chaos as little as 4 years ago are being exacerbated by the Mutual Funds which are also raising capital to pay their annual distributions. As the high flyers crash, more shares have to be sold to bring in the same amount of cash. Since their investments were Global in nature and Billions were invested abroad, foreign currencies raised are being sold and converted into dollars.This is a Global phenomena. The Yen was predominantly used by the carry trade and Japan never really attracted many buyers because Too many Japanese corporations own too many shares of each other.

The dollars rise will stop when either the Fed cuts rates decisively which should be any day now or Hedge Funds curtail redemptions. The Fed can not afford to appear to be Political by cutting rates just before a Presidential Election, they will do so long before or shortly after but not at the end of the month.

The Lemmings are all running together now. Valuations are meaningless, Trailing PE's mean squat.

Take DRYS for instance. It instituted a dividend last Monday. Its trailing PE is less than 2.

2008 Oct 02 10:27 PM