Optimism

We gave reason for optimism, Oct/23 and Oct/29, that the worst of the liquidity crisis may be behind us. At this writing we are further encouraged that this is so, noting for example that interbank lending rates are tumbling, 90 LIBOR last at 2.71% from 4.82% just a little over three weeks ago. As expected Australia’s central bank cut its benchmark rate. Look for the EU and Bk of Eng to follow on Thursday. The heart of the system is beating again. There is a ton of work to do, many, many unknowns (at least to us), but the free-fall is history.

Our banking system is in relatively good shape compared to some others. Be thankful we are not Europe. As we highlighted earlier, here is the next potential avalanche (but it too is at least partially priced in by now). European and UK banks are five times more exposed to emerging markets than US banks. They alone hold what one observer called "the collective time-bomb of $1.6 trillion (£990bn) in hard currency loans to Eastern Europe – now starting to detonate in Hungary, Ukraine, Romania, and even Russia." This is their very own credit bubble. This will slow the world's recovery to be sure but it will not create another free fall; a system is now in place to prevent that.

The other prime consideration for all of us of course remains the US real sector. Yesterday’s manufacturing and veh sales data were worse than expected. Here of course we see the results of contagion. For example, the seizing up of the credit markets, plus course weakness in the labor markets put vehicle sales in the out house, sales of autos down over 10% to the lowest level since 1961. We have the key Oct payroll release on Friday. It will be very weak but at this point such weakness is priced in so that it will not be a shocker, our view.

In spite of lower US eco growth, lower Treasury yields and lower employment, the $ continues to strengthen vs all other major world currencies except the Yen. Why? Much is so-called "flight-to-quality" - world institutions seeking safety in US securities (still the world’s safest). And part is the great deleveraging as it has become known - problems elsewhere. Many investors have been following a version of the "carry trade," borrowing money in a low-yielding currency. All they had to do was earn a higher return from assets in higher yielding currencies than the cost of their financing. Since the two currencies with the lowest yields over the past year have been the dollar and the yen, those were the natural ones to borrow. However, when asset prices fall in Brazil, Russia, the Ukraine, Indonesia and elsewhere, this strategy is disastrous. Investors dash to sell assets and repay their debts. Since those debts were incurred in dollars and yen, that means they have to buy back those two currencies—hence their sharp recent rises.

Robert Craven