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No, the Fed rate cut has not addressed the underlying problems, even if it was a necessary step to prevent immediate economic collapse. The sub-prime crisis is far from over, our own interaction with market-makers shows that liquidity has not improved significantly, and consumer confidence on both sides of the Atlantic is on the slide. Moreover, the lower Fed rate is hastening the decline of the USD and beckoning inflation in the USA. |
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Due to resets there will be major increases in interest payments in November for adjustable rate mortgages (ARMs). The interest rate on USD 350 billion of mortgages will rise typically from 7% to 10%, affecting 2.5 million borrowers. Lehman estimate that 1.5 million of them will default (actually they say 1.5 million will be foreclosed, but what are banks going to do owning 1.5 million houses?). The reason a lower Fed rate does nothing to affect this menace is that ARMs are mostly linked to Libor at six months, and that number has not declined with the overnight rate. |
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The obvious reason for the USD's further decline is the lower interest rate, although, just as for ARMs, longer term yields have not dropped with the Fed rate. We surmise therefore whether a fundamental change of attitude is taking place, much as we pondered many months ago, viz., that the key supporters of the USD (China and the Middle East oil producers) are at breaking point with their patience for holding a depreciating asset and importing inflation. Political undercurrents are also entering into this equation. Even America's friends like Kuwait and Saudi Arabia have unpegged their currencies or are thinking about it. The USA is not exactly the most loved geo-political player in the Middle East. Moreover, the Mattel fiasco over toy design faults by Mattel itself, and not by its Chinese suppliers, cannot be making China feel warmer to US interests. While the "rest of the world" would never have deliberately sought such a challenge, it is now ready to face one that is being forced upon it: economic growth without reliance on the excess spending of the USA. |
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Of one thing we are becoming more and more sure, time is running out for the USA to live on borrowed money. Rebalancing the world economy is taking a major step forward as the US economy slows. Slow it will, as household spending power declines along with house prices. As if that were not enough, the GM strike, if not settled quickly (which fortunately seems likely) would be incredibly damaging to the economy. True, a cheaper USD will help US exports, but it will do nothing to stop house prices falling. The rebalancing will be painful for everyone, but better now than later, and a necessary step towards a new, more smoothly running world economy. |
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If the USA faces a slowdown and possibly a recession, together with inflation, should an increase in long term yields be expected? The short answer is "yes, but not immediately". We are therefore not going to change our recommendations on fairly long maturities for the USD yet, but we must monitor the inflation issue very carefully. |
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We must also monitor the UK economy. Some (fortunately not all) of the ingredients of the US housing collapse and credit squeeze are present in the UK, notably huge household indebtedness and high house prices. The behaviour of the GBP is emblematic: up against the USD, down against the EUR. It is as if the currency and the country were feeling their way between an overspending USA and an underspending euro zone. |
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Deutsche Bank are to be admired for practising their own advice to reveal their sub-prime/CDO losses. The sooner everyone "confesses" as to what losses they are incurring, the sooner liquidity will return. |
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Focus |
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(–) US economy: Bernanke sees the global financial market problems resulting from sub-prime failures as causing losses greater than even the most pessimistic forecasts. |
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(–) USD yields: paradoxically, US long term yields (30 years) have tightened by about 15 bps since the drop in the Fed rate |
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(–) Russia: the issue of Putin's succession remains one of the few negative elements in an otherwise very promising economy |
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(!) GB: Northern Rock is in negotiation to be acquired and has cancelled its dividend payment |
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(+) positive for bonds (-) negative for bonds (!) watch out (?) begs a question |
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