Bailout Politics and the U.S. Dollar
As the $700B U.S. bailout package for Wall Street is debated, voted on and postured over by lawmakers in Congress, financial markets around the world convulse over the political disarray in both parties regarding the Paulson plan. Pandemonium erupts once the House votes are tallied and the nays have voted down the bill. Like a tempestuous child denied a promised treat, Wall Street throws a seismic temper tantrum and hits the SELL button. Stocks plunge, Treasuries soar, commodities tank and yet another round of morning headlines warn of financial Armageddon. Another vote by the House is imminent after the Senate passes the revised bill.
According to news reports, voters calling into their Congressmen’s offices are overwhelmingly against the proposed bailout. However, what some in Middle America fail to understand, through no fault of their own, is that the U.S. and global economies sit on the knife’s edge of falling into an abyss where not only stock markets are in peril, but even the mundane aspects of operating a business, like getting a loan or meeting payroll, are threatened by the credit crunch.
Unfortunately, but not unexpectedly, this crisis has been seized upon by politicians, most of whom have little understanding of economics and financial markets, to mischaracterize the debate as siding with either Wall Street or Main Street. They delight in scoring political points off their opponents, while abdicating their responsibility to explain to constituents the need for action. The media, ever so eager to exploit conflict and dramatize political brinksmanship for the sake of ratings, deserve no credit for educating the public either.
For the typical member who votes down the bill, the high minded ideal of “Country First” quickly yields to the political reality of a close re-election fight in his home district. Rather than having the courage of leadership to do what is right for the country and risk the wrath of the constituents, he will just submit to the wishes of his ill-informed electorate to save his own skin.
Political theatre it may be, but it is still a breath of fresh air to hear lawmakers in both parties suddenly profess their resolve to protect the taxpayer’s hard earned dollars against the tyranny of Wall Street. “Greedy behavior on Wall Street must not be condoned!” “Taxpayer money must be protected!” Congressional leaders thunder to the approval of their membership and for the benefit of the voters at home.
Sad truth be told, the U.S. taxpayer has long run out of money, courtesy of the misguided policies of the president, aided and abetted by the free spending mob on Capitol Hill. Now a near paralyzed global financial system is also drying up credit on Main Street. This vast sum to be invested in illiquid assets by Paulson Inc. on behalf of Joe Taxpayer has yet to be earned, borrowed, or printed. As usual, it is the next generation and beyond who will be saddled with the true cost of the greed and extravagances of their forbears.
While markets fret over the financial crisis spilling over to Main Street, there is scant mention of the looming fiscal crisis that is exacerbated daily with ever more government bailouts. On the campaign trail, both presidential candidates promise to support the rescue package, with more spending programs and more tax cuts if either is elected, seemingly oblivious to the catastrophic impact of their follies on the soaring debt and deficits.
Senators McCain and Obama both know that the crushing debt levels in America today are crippling personal and government finances. And yet, ingrained in the DNA of the voters is their sense of entitlement and gratification which no politician has the courage to challenge. So spending programs remain sacrosanct, tax cuts are either extended or made permanent, while governments, businesses and consumers sink deeper into debt.
Global financial markets are being forced to de-leverage in a new climate of credit contraction. With a reduced capacity to borrow, the U.S. consumer and his spendthrift government will similarly find themselves in the predicament of having to make the hard choices between earning more or spending less. For the consumer, it means qualifying for a better paying job or cutting back on his expenses. For the government, it means higher taxes or reduced spending. But, as deficits explode into the stratosphere, only a combination of higher taxes AND lower spending can stanch the bleeding, and that is a tough message to deliver.
Against conventional wisdom and catching many off guard, the U.S. Dollar rallied sharply against the Euro over the summer. Since reaching a high of 1.6035 on July 15th when the Federal Reserve and Treasury were granted extraordinary powers to take over Fannie Mae and Freddie Mac, the single currency plunged to a low of 1.3885 against the U.S. Dollar by Sep 10th, before settling into the recent lower end of its range. Since then, the Teflon-coated Dollar has extended its gains, deflecting the continuing barrage of negative news about the U.S. economy. The next key support level for EUR/USD is 1.3665, a prior significant peak for the Euro in December 2004.
Many changing narratives have emerged from the financial press to rationalize the strength of the Dollar and the weakness of the Euro. Some argue that the Dollar is benefiting from the rapidly weakening economies of the Euro zone. Some say the market is rewarding the pro-active stance of U.S. policy makers towards the credit crisis, recent legislative debacle notwithstanding. Others attribute the Euro weakness primarily to the deterioration of the Euro zone banking sector whose problems until recently have been overshadowed by the turmoil in the U.S.
Another possible explanation behind the resurgent U.S. Dollar is the repatriation of investment capital from overseas markets by U.S. fund managers. As credit is tightened and interest rates rise, it affects not only lending to consumers, home buyers and businesses. Some hedge funds which have amassed huge short dollar positions on generous credit or margin terms are now forced to reduce or unwind these positions as their benefactors scale back lending facilities. Risk appetite is curtailed across the entire investment landscape, and risk aversion is the new financial world order of the day.
As trading desks are forced to de-leverage en masse due to the unprecedented credit crisis, traders rush to exit positions which can add to losses. This prompts redemption by nervous clients and pressure some fund managers into margin call situations, which require further liquidation. The net effect of this de-leveraging process is the squaring up, or buying back, of short U.S. Dollar positions, which has fueled its recent explosive rally.
Is this Dollar strength temporary or does it portend the reversal of a long term trend? Its recent performance seems to suggest the moves are more flow driven than a reflection of economic fundamentals. Currency traders are equally divided over its future direction. If one is convinced that the ultimate fate of the Dollar is inextricably tied to the fiscal health of the country, then it is difficult not to be bearish on the greenback in the long term. However, if one believes that the relative performance of the currency over the immediate horizon is a function of aggressive policy action to tackle the banking and credit crisis, then the Dollar may actually hold an advantage over the Euro.
With the latest brokered sale of Washington Mutual and Wachovia, Secretary Paulson has almost single-handedly rearranged the entire landscape of the U.S. banking system, which will be dominated by only three major players: Bank of America, Citigroup and JP Morgan Chase. In just over six months, the famed investment banks of Wall Street at the pinnacle of American high finance have all disappeared through bankruptcy, being acquired or reinventing themselves to survive the turmoil.
Subject to the final outcome of the $700B rescue plan, the light speed consolidation of the U.S. banking sector feeds the perception that the U.S. is responding more forcefully to the crisis whereas European regulators are only waking up to the dire conditions of its own financial institutions, many of whom are just as highly leveraged and impaired as their failed U.S. competitors. Under these circumstances, a forward looking Forex market inclined to discount negative U.S. news will likely focus on the emerging vulnerabilities of the European financial system and give the benefit of the doubt, at least temporarily, to the U.S. Dollar.
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