Market crisis or mass hysteria?

Market crisis or mass hysteria?--BD
As Bart Simpson might say: “Ay Carumba!” As shareholders of certain GSE’s might say: “Mommy.” This past week started out with the USD on the mend and oil and other commodity prices dropping sharply only to turnaround mid-week and see the USD plunge to near all time lows and oil prices surge to new record highs. The causes for the sudden shifts are as unrelated as they are sudden, and, I believe unjustified. But this is the state of the world we live in now: doom and gloom pervades, and panic is just a step away. The US dollar’s woes stem largely from a flight out of US assets over fears that key GSE (government sponsored enterprises) mortgage lenders are on the verge of collapse. Oil’s surge is attributed to heightened tensions between Iran and Israel, with a fair amount of rumor and subterfuge behind those tensions. In both cases, mass hysteria seems to have got the better of markets and this is cause to treat the price movements with suspicion. From a trading perspective, however, market hysteria frequently overwhelms facts in the short-run and traders are strongly urged not to stand in the way of a panicked mob. Instead, wait for signs in price movements that the moves are reversing.

On the GSE’s, the fire looks to have had some gasoline thrown on it by a former District Fed president (who is now hopefully in hiding on some small island and away from microphones), when he suggested two key GSE’s were technically insolvent. While it’s true their stock prices have been slumping all year alongside any other housing-related shares, these comments sparked a death spiral. Fears of a US government takeover, which would protect debt holders but cause shareholders to lose all, subsided somewhat after US Treasury Sec. Paulson indicated that the administration and the GSE’s regulator (OFHEO) are intent on keeping them in their ‘current form,’ meaning no government takeover, and that shareholders’ worst fears would not be realized. And that is because the facts do not support the notion that the GSE’s are short of capital. Saner analysts, and OFHEO, were quick to note that the GSE’s are adequately capitalized to withstand expected losses, and that additional plans to raise capital are in the works.

Fear and panic, however, led some investors, especially foreign asset managers to dump US Treasury debt (and sell the USD proceeds for repatriation) out of the misguided belief that US government debt would effectively double in the event of a US government bailout of the GSE’s. (In the event of a takeover, the US government (taxpayers) would only be responsible for operating losses, i.e. likely tens of billions, not the full size of the balance sheets, i.e. trillions.) Ratings agencies were quick to debunk that notion, but again irrationality persisted. Not until the end of the day, when word came out (as yet unconfirmed) that the Fed had told the GSE’s chiefs that the Fed’s discount window was available to them, did the panic show signs of subsiding.

I believe cooler heads will return over the weekend, and I look for this turmoil to subside with consequent positive implications for the USD and US debt. However, traders need to wait for clear signs from prices that this is taking place. EUR/USD is going out near the top of its range and the immediate upside bias remains while above the 1.5850/80 area; 1.5950 is the trigger to a fresh test of the all-time highs around 1.6010/20. USD/JPY looks set to close below critical Ichimoku support at 106.50, with 105.50/60 as the gateway to fresh weakness likely into the 103.50/104.00 area initially. In particular, be on the lookout for some form of US government statement prior to the open of Asian markets on Monday morning/Sunday evening NY time.

The oil concerns are more difficult to interpret, involving as they do unknown intentions of Iran and Israel. It appears that behind the heightened tensions there is a fair amount of bluster and saber-rattling. Earlier in the week, Iran’s president had indicated that war would be avoided, and this contributed to the oil sell-off early in the week. The hardliners in Teheran evidently thought a tougher show of force was needed, and a few missiles were fired off in a blatant ‘psy-ops’ show of force. (Similar missiles were test-fired earlier this year and no advances are thought to have been on display.) The latest rumors were that the Israeli air force was practicing in Iraqi airspace for a strike on Iran, which the IAF denied. Oil resisted the urge to move higher for nearly 48 hours until it broke above about $138.50/139/bbl, suggesting short-covering was more responsible for the surge than actual conviction buying. Oil shorts have now been ruthlessly chased out of the market twice in recent months, but, again, this is cause to view oil’s price gains with suspicion. In the fundamental sphere, demand destruction is taking place as major economies slow, reducing final demand, and Iran is set to begin talks with EU negotiators next week on an enhanced package of incentives. In the meantime, the positive correlation between oil and EUR/USD, negative for the USD elsewhere, remains operative.

Intervention risks mounting--BD
In case the panic continues, the USD is set for some further pain. As I have argued above, the fundamentals do not justify this current phase of market dislocation. US government officials have been arguing along similar lines, with Senate Banking Chair Dodd on Friday saying that the GSE’s did not even need to raise additional capital. This suggests a ‘disconnect’ between reality and market concerns, with the result being market disarray that threatens to deepen and prolong the US (and others') downturn. In a panicked environment such as this, intervention to support the USD is a strong and relatively inexpensive way to stabilize market conditions until rationality returns. I would suggest that the risk of intervention to support the USD is at the highest since the sub-prime crisis began. It’s one thing when the USD is weakening on the back of falling US interest rates and slowing growth, but it’s altogether different when it falls on a misplaced crisis of confidence, as I believe to be the current case. To stave off an even greater downward market spiral, Treasury may very well need to deliver a ‘slap in the face’ to jar markets back to some semblance of order. I would be very careful about selling the USD in the current environment.

The US outlook is actually stabilizing – JO
We believe we have put in a bottom in terms of deteriorating US economic fundamentals and this week’s data were a case in point. Doubtless that the two main factors impacting the economy -- housing and credit markets -- still pose some downside risk, but we expect the excessive losses in these areas are behind us. Moreover employment does not look dire, sentiment looks to have bottomed, and consumer spending continues to beat expectations.

Housing data still look paltry to be sure, but the fact that home prices have already tumbled more than 15% and that home sales activity has not deteriorated in the last six months (existing home sales were 4.91M in December and 4.99M in May) suggest that the worst has past. Indeed, this week we saw mortgage applications rise for the second consecutive week as potential buyers take advantage of the bargains brought forth from desperate home builders and the plethora of foreclosures.

On the employment front, the news does not look dire either. While we have shed jobs in each of the first six months of the year the declines pale in comparison to historical downturns. Moreover, initial jobless claims are not even close to recessionary levels. While they are averaging around 380K over the last four weeks, when we account for the size on the labor force claims are nowhere near what we saw in past economic downturns. In fact, by this measure claims are lower now than they were back in the 1995 mid-cycle slowdown.

Even the downtrodden consumer sentiment numbers are beginning to show signs of bottoming. The preliminary read for July sentiment from the University of Michigan showed the first improvement in confidence in six months and the weekly surveys are showing materially better numbers as well. The risk here is that the renewed tensions in the Middle East escalate and take oil beyond $150/bbl, which would push prices of gas at the pump higher and weigh down sentiment. On the upside though, demand destruction seems to be in full effect as evidenced by the last few weeks of gasoline stockpiles which were above market expectations and this is likely to keep a cap on oil price increases near-term.

Last but not least, the US consumer is making the most of the already distributed +$85 billion of fiscal stimulus. Spending is up as evidenced by the latest chain store sales data for June which showed an annual increase of 4.3% in sales. This shattered the market expectation for a 3.3% advance and was much higher than the 2.9% result the prior month. While luxury store sales continue to suffer as consumers shift shopping habits and furniture store sales crumble under the weak housing market, the US shopper has clearly not rolled over and died. And for those who believe the downturn will come once the stimulus impact dissipates, renewed chatter about “fiscal stimulus II” should quell those worries as we expect the government will want to avoid an economic downturn at all costs as the November election looms. The stabilizing fundamental US outlook provides another reason to argue against wholesale USD selling, especially when viewed in contrast to emerging signs of fresh weakness in other key economies, most notably Europe and the UK.