GSE Bailout - Impact on USD

Daily Forex Fundamentals | Written by Danske Bank | Sep 09 08 14:50 GMT |

There can be little doubt that the weekend's bailout of Freddie Mac and Fannie Mae (please see Freddie and Fannie rescue) will influence market activity in the coming days. We have already seen the first response: yields are higher, so are stock markets, the USD is a little weaker overall and high-yielding and commodity-based currencies have rallied strongly. But the question to ask is: has anything changed? First of all, it is important to understand that the past few weeks have seen significant movement in currency markets. The one-month decline in both EUR/USD and in G10 carry performance has both surpassed 100% annualised, exceptional moves by historical standards (charts 1 and 2). The key theme behind these moves has been an outperformance of funding currencies such as JPY and CHF and an outperformance of USD vs. EM and commodity-based currencies. As always after such sharp moves, the risk for a correction is substantial. Second, what does the GSE bailout imply? On the margin it is positive for the US economy. It is likely to help stabilise the housing market and it will make it easier for the Fed to raise rates. It is, on the other hand, negative for the US budget position, and the cost for the taxpayer is likely to be significant. But taken together it is hard to see the GSE bailout as negative for the dollar, though one has to be mindful of the negative implications for the fiscal position in the medium term. Third, the GSE bailout does nothing much for the rest of the world. It does little to support ailing economies in Europe. It does not change the outlook for rate cuts in Australia and New Zealand (RBNZ likely to go ahead this week, RBA cut last week). It provides little help for unbalanced Asian economies. In short, the global economy will remain on a decelerating trend even after this initiative. Fourth, the bailout sprung from necessity, not from a desire to nationalise mortgage issuers in the US. We are not convinced that we have seen the peak in the financial crisis and we continue to expect further financial losses, not least outside of the US. And finally, our concerns over FX valuation remain. EUR, AUD and NZD remain overvalued. JPY, CHF and USD remain undervalued. In summary, currency markets were due a correction after a prolonged period of risk aversion. Risk-seeking may dominate in the near term, as was the case after the initial Treasury initiative towards GSEs on 13 July and the Bear Stearns rescue package on 16 March. But the underlying climate remains hostile towards risk, based partly on a global slowdown and partly on an expected further retrenchment of financial leverage, including in housing markets. As the bailout must be seen as positive, at least on the margin, for the US economy, it is difficult to see it as negative for the dollar. As a result, we stay with our expectations for a further decline in EUR/USD, in USD/JPY and in EUR/JPY. Danske Bank http://www.danskebank.com/danskeresearch