to Plunge and
Thursday, 09 August 2007 15:16:20 GMT
Written by Kathy Lien, Chief Strategist
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There is no denying the fact that the subprime problems have now gone
global. This morning, France's largest bank, BNP Paribas SA announced
that they were freezing withdrawals from three of their investments
funds following the "complete evaporation of liquidity." For BNP,
this may not be a big deal because the three funds represent only 1.6
billion out of the 356 billion euros that they have under management,
but for the rest of the world, this is huge.
The victims of the subprime contagion is no longer limited to just
small banks, and mortgage lenders, but is now hitting Tier 1 banks
around the world. As a direct result of BNP's announcement, overnight
LIBOR rates skyrocketed to six year highs, stocks plummeted and carry
trades sold off across the board. The situation became so severe that
for the first time since 2001, the ECB stepped in and injected
liquidity into the markets. The latest liquidity squeeze has broad
ramifications for the global markets. Flight to safety will become
the new trend, especially if we see a sharp increase in margin calls.
Traders and investors will be moving back to cash, which in most cases
means that they will be parking their money in US dollars. The
greenback is already stronger against every major currency with the
exception of the Japanese Yen and this is only because USD/JPY is a
carry trade currency.
ECB and Federal Reserve Step In
This morning the LIBOR rate rose by the fastest pace since June 2004,
triggering a wave of concern amongst central banks. In dollar terms,
the overnight lending rate jumped from 5.35 percent to 5.86 percent, a
six year high. Euro rates climbed to 4.7 percent, while sterling rates
hit 6.16 percent (both are new 6 yr highs). Fears of a credit crunch
forced the European Central Bank to step in and inject EUR94.8 billion
in emergency funds to calm the markets. The last time that the
central bank injected liquidity was right after 9/11, which gives the
market a gage of how serious the credit crunch has become. In fact,
the amount injected in September 2001 was only EUR69.3 billion, 25
billion less than today. The Federal Reserve followed suit by adding
$12 billion in temporary reserves via 14-day repurchase agreements.
Unlike the ECB however, the Fed does repurchase operations every week,
the only difference is that the repurchases today were more than
double the amount done last Thursday. Both central banks are trying
desperately to calm the markets. Even the Bank of Canada issued a
statement saying that they are ready to add liquidity to the Canadian
financial system, if necessary. Conditions must have deteriorated
significantly because as recently as two days ago, the FOMC statement
indicated that tighter credit conditions were not a threat. The same
sentiment was relayed by the ECB last week.
Is this the Beginning of the End?
The age of easy money is over and unfortunately, we expect more
problems to come. We will not hit the peak in adjustable rate
mortgage resets until October, when $50 billion in mortgages will
switch to the current market rate. After that, $30 billion in
mortgages will be reset through September 2008, followed by a sharp
fall afterwards. This means that the risk of defaults and late
payments will only continue to grow. Lenders will retrench further
and if the problems exacerbate, it will also raise the risk of a
recession. Volatility indices are up across the board indicating that
risk aversion is growing. For the financial markets, this has broad
ramifications:
Market Ramifications
Caution with Carry Trades: Long Yen traders will probably make out
better than those who are still short Yen. Carry trades thrive in low
volatility environments and the recent movements in the financial
markets is anything but low volatility. Over the past few years, the
popularity of carry trades has made speculation in Japanese Yen
crosses a very leveraged bet. As a result, big moves lower could
easily trigger margin calls. The principle of gravity applies well
here – things fall much faster than they rise. According to one of
our previous Carry Trade Special Reports, the maximum drawdown in a
basket carry trades over the past decade was 10.5 percent. We have
drawn down less than half that amount at this point.
Further Losses in the Stocks: US stocks could also continue to suffer
as investors reduce risk. In the first half of the year, leveraged
buyout deals and stock buybacks fueled a sharp rally in equities.
With the current credit crunch and liquidity squeeze, not only have
these deals been cancelled, but we expect lenders to be far more
selective in the months to come. Unless the Fed sweeps in with a 100
basis point rate cut tomorrow, do not expect the Dow to return to its
all time highs. See our Special Technical report on the Dow and
EUR/JPY.
Rise in US Dollar: In contrast, as the carry trade and other
leveraged bets become unwound, those assets will be parked back in US
dollars for the time being. Do be careful however since the safe
haven status of the US dollar could be counteracted by the possibility
of the Federal Reserve lowering interest rates.
Federal Reserve September Cut?: The futures markets have now fully
priced in a 25bp rate cut next month. This is a sharp shift away from
yesterday's 20 percent probability. If this is true, the Fed will
have to make some sort of announcement expressing their shift in
stance. Although we do think that the subprime problems are severe, a
September rate cut may be a bit premature. Yields on bonds have
already fallen in response to the moves by the central banks today.
ECB September Rate Decision: Unlike the Federal Reserve or other
central banks around the world, the ECB is prohibited from bailing out
banks or anyone for that matter. Therefore if the blowups escalate
and yields to not regulate themselves, the ECB could change its mind
about raising rates in September. For the time being however, current
conditions should not alter the central bank's plans to raise interest
rates in September. They are offering liquidity at the current level
of interest rates (4.00 percent) and not at a lower rate.
Today's developments could be the beginning of a major shift in the
financial markets but even if it is not and US stocks manage to
recover most of its losses, it is still important for traders to be
prepared because volatility has returned and it is not likely to go
away soon. For those who still want to hold onto existing positions
that have become vulnerable to recent market movements, it will be
even more important to look into hedging your portfolio with different
asset classes until calm is restored in the markets.
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