Forex Investment and Currency Trading

The crisis in the financial markets is one of confidence/uncertainty about underlying asset values which has stopped markets from operating as they would under normal conditions. The Fed’s responses to this market turbulence have been aggressive and often innovative with the creation of new facilities to provide liquidity to various participants in the financial system.

Nevertheless, market sentiment remains quite delicate, and the Fed has little choice but to squarely focus its efforts on stabilizing the financial markets. If needed, the Fed’s next step may be to actually buy (not swap) government-sponsored enterprise (GSEs such as Fannie Mae and Freddie Mac) guaranteed mortgages directly from the market for cash (or UST securities). This would improve the balance sheets of the banks by replacing illiquid assets with highly liquid ones. The Fed has already shown a willingness to use its balance sheet as its knows that the cost of a downward-feeding spiral of lower asset prices, further forced selling, and further asset price declines is unacceptably high.

It is also clear that the Fed has done all the heavy lifting so far. This puts pressure on the Treasury and Congress to act. One possibility before Congress is USD 300-400bn in federal guarantees for mortgage refinancings. Another is to make the GSEs’ implicit credit line from the Treasury an explicit one, thereby guaranteeing those securities. But Congress is in recess for the next two weeks so we are not likely to see anything in the near term. One possibility in the near term is an announcement from the Treasury and Congressional leaders with pledges to work together more closely and even preview new legislative initiatives.

But any such announcements would have to be pretty explicit to get the market’s attention as it would take time to get any new legislation done. Most recently, the Fed cut its target funds rate by another 75bps (to 2.25%) at the March meeting, and we continue to expect the target rate to go as low as 1% by mid-year. But beyond that, time is what is really needed once the markets stabilize. As mentioned earlier, the Fed has done a considerable amount (from a 5.25% target rate in Sep) in a relatively short period of time. We do not think that the Fed is powerless here.

But the underlying cause of recent problems – the decline in home prices – looks to continue in the near term. There has been a large adjustment in the housing market already though more needs to happen. There is still a large overhang of unsold homes and that keeps downward pressure on new and existing home prices.

Further, tighter mortgage standards and falling employment will take a toll on the demand for new homes. The Fed’s actions can try to stabilize market panic, but time is needed to repair balance sheets.

In the longer term, fundamentals will likely prevail and the economy will recover. When that will occur is becoming less clear as a result of the market turbulence. In recent reports, we have highlighted the importance of consumption to the US (with 70% of GDP coming from consumption). So it is crucial to have a sense of household balance sheets when thinking about when we could see spending recover.

The Fed’s Flow of Funds Report for Q4 gives us some insight into the state of the consumer prior to the latest vicious moves in the credit markets and the decline in home prices has hurt wealth further. Household net worth fell 0.9% from Q3 to Q4 (not annualized) and stood at 5.6 times disposable income from 5.7 times disposable income in Q3. The continued decline in housing prices reduced household real estate assets to USD 22.5 trillion in Q4 vs. USD 22.6 trillion in Q3 for the first quarterly decline since Q1-93. Lastly, homeowners equity in real estate assets fell 3.9% y/y in Q4 – the biggest decline on record. On the plus side, household financial assets rose to USD 12.9 trillion in Q4 from USD 12.7 trillion in Q3, and rose 4.5% y/y. However with US equity markets in negative territory year to date, household financial assets likely are down from Q1. The plunge in consumer confidence from Jan to Feb is already ominous for near-term consumption. Energy prices are on the rise and that is another worrisome headwind for the consumer. Oil is over USD 100/bbl and retail gas prices are rising.

For the week ending 17 Mar, the average price at the pump for gas was USD 3.28/gallon, up from USD 3.04/g one month ago and USD 3.00/g at the start of the year. A common rule of thumb is that each USD 0.01/gal rise in the cost of gasoline on an annual basis means households will spend an additional USD 1bn on energy-related products. In other words, that means USD 1bn less to spend on non-energy, discretionary items. If gas prices rise much further the risk is that the stimulus envisioned by the Treasury and the Congress via the income tax rebate checks to be sent beginning in May will be spent on
energy costs.

In the near-term, the Fed’s clear focus is on preventing a downward spiral of asset prices, further forced selling, and another round of asset price decline which would freeze the banking system. The near-term outlook for growth has worsened and the best short-term outcome the Fed can hope for is to free up the logjam in the financial markets. Over the medium term, fundamentals will take over but clearly time is needed for balance sheets to be repaired. The consumer is key here, and rising energy prices (plus the labour market) pose another risk to near term consumer spending.