|The World in Crisis: Where are the Safe Havens?|
In late 2006, we forecast the ensuing surge in volatility to unwind the unprecedented credit expansion that had taken place in the previous years. When the crisis first started, we argued that the markets dealt with a valuation, not a liquidity crisis: financial institutions were unwilling to sell off assets on their books out of fear of jeopardizing their capital ratios. By now, the valuation crisis has morphed into a liquidity crisis where financial institutions don't trust one another; inter-bank lending is grinding to a halt. The business model of most commercial banks consists of borrowing short-term funds to provide long-term loans; if short term funding is not available, central banks step in as the lender of last resort. Consumers, investment banks, large corporations, municipalities and states alike have realized that they do not have a central bank as a lender of last resort; when short-term funding dries up, they may have to file for bankruptcy protection even if they are otherwise financially sound. Quite simply, unless one can afford the risk of not obtaining refinancing, we believe long-term projects ought to be financed with long-term loans.
Accessing the lender of last resort for overnight funding requirements is generally frowned upon. Banks that may need to access the Federal Reserve (Fed) "discount window" or one of its new short-term facilities tend to reign in their lending activities to hoard cash; this is motivated by a desire to rebuild the balance sheet so that at some point reliance on the Fed may no longer be necessary. Similarly, if they were to access the interbank lending market at what is currently a very high rate, they would eventually have to pass on the elevated cost of borrowing to their customers. This makes credit availability "tight"; in a credit driven society, this is bad for economic growth. Hoarding cash to rebuild your balance sheet quickly becomes a habit - just as the Japanese or those who are still around to have experienced the Great Depression. A depression is not merely a severe recession; it is a state of mind.
Because of these concerns, policy makers want to jump start credit markets, especially short-term money markets, at just about any cost. The Fed just announced an increase of its Term Auction Facility (TAF) to over $900 billion; the TAF effectively allows financial institutions to park a broad range of collateral in return for cash with the Fed. The bailout plan approved in Congress tries to be a tool in Treasury Secretary Hank Paulson's "toolbox"; a coordinated interest rate cut throughout the world may be applied with the same objective. One should not underestimate the will of the Fed to throw money at the problem; at the same time, the Fed has underestimated the markets' resilience to make that money stick.
So far, efforts by policy makers have been ineffective. It appears that, at least for now, central banks may be losing control of the situation as massive liquidity injections are simply not enough to stabilize the credit markets. Much of it is because, in our assessment, the Federal Reserve has been losing valuable time by employing inefficient policy tools. Amongst them is that the cutting of interest rate had been mostly ineffective while we had a valuation, not a liquidity problem; now as we have a liquidity problem, the Fed has less ammunition. Similarly, the $700 billion bailout approved in Congress may be ineffective if it is not used to improve the capitalization of financial institutions, but merely replaces bad assets with good assets; this move may be helpful, but is not enough. Again, valuable ammunition is wasted should, to name potential challenges ahead, the credit continue to be seized up; should the automotive and airline sectors deteriorate further; should the anger in public increase and the mood in Congress to reach constructive solutions worsen; or should the consumer slide further into recession.
The implications of all of this heavily depend on how governments interfere in the markets. Without interference, only the strongest institutions may survive. That's why the large U.S. financial institutions, in particular JP Morgan, Bank of America, Citigroup and Wells Fargo have experienced substantial inflows in recent weeks, at the cost of small banks. To stem the flow out of small institutions, Congress has increased FDIC insurance. In Europe the same trend can be observed with HSBC, Europe's largest bank, experiencing large inflows - despite HSBC's exposure to the U.S. subprime market through its 2003 acquisition of U.S. based Household International -, but many smaller or weaker institutions experiencing outflows. European governments are scrambling to issue guarantees for depositors to stem the tide; one may take note that many of these guarantees only affect personal, not business accounts. There is the danger that governments may not be strong enough to bail out their financial institutions. Iceland, in particular, has seen not only a flight on its institutions, but also on the currency; as the crisis deepens, there is the real fear that Iceland may become insolvent. For the time being, Iceland is negotiating a loan from Russia and is attempting to peg its currency; as of this writing, it is not sure whether this will work as trading liquidity dried up as a result as the unofficial exchange rate is about half of what the peg would suggest.
As most know by now, not all cash is the same. The U.S. government has taken steps to shore up confidence by, for example, temporarily increasing the insurance on FDIC insured deposits; or providing assurances on money market funds. Still, we have seen brokers transfer units of money market funds rather than cash for intra-broker transfers; this is a legitimate practice, but shows the strains in the money markets. One safe alternative is the purchase of U.S. Treasury Bills; the challenge is that the yield on a 4-week T-Bills is just above zero, possibly negative after commissions. Given the volatility in the current markets, it is possible to lose money if one needs to sell the T-Bills before they mature should they drop in value. Recently, we were unable to buy a 3-month T-Bill because the yield would have been negative. Imagine the strain on money market funds that don't want to touch any commercial paper, but have to keep a stable net asset value, after expenses. Many Treasury-only money market funds may engage in overnight repurchase agreements; this may allow such money market funds to get sufficient return to keep a stable net asset value after expenses, but it is not what investors in these funds necessarily expect. To some, but certainly not all, it may be reassuring to some that the government provides a backstop to money market funds. Some opt to take the cash and put it under their mattress, literally. In California, everyone is encouraged to keep an emergency pack in case of an earthquake; why not also hold some cash and gold coins just in case the financial system seizes up? Financial institutions are hoarding cash, why shouldn't you? Please note that this is not investment advice, but food for thought.
How will this play out? In recent days, there has been a flight to cash, U.S. dollar cash. The violent deleveraging has accelerated and the only currencies that have benefited from this are the Japanese yen and the U.S. dollar. The U.S. dollar has returned, at least for the moment, to its safe haven status. This has become a fairly common phenomenon in recent crisis, but did not necessarily last; U.S. investors repatriate foreign investors in times of crisis; as a second wave, they then decide how to deploy them. The challenge with holding U.S. dollar cash is that it is also not without risk because one can never underestimate just how determined the Federal Reserve is to get the credit markets going. Fed Chairman Bernanke has been critical of how the Japanese handled their banking crisis in the 1990s because they Bank of Japan was not forceful enough in pre-empting the crisis. This is part of the reason the Fed and the Treasury were pushing for the $700 billion bailout before the crisis was felt on Main Street. Japan, unlike the U.S., however, does not have significant foreign creditors; the U.S. is crucially dependent on foreigners to support the currency. Fannie Mae and Freddie Mac were quasi-nationalized after foreigners no longer bought these agency papers, causing a 94.5% drop in foreign investments in the U.S. in the 2nd quarter. Foreign investments have since returned, but foreigners have every right to be nervous on how the Treasury and the Fed steer through the waters. In the latest developments, the Fed has indicated that it will buy commercial paper directly; the initial positive reaction is that this very targeted action does indeed help the commercial paper market; the negative reaction is to the dollar that is reacting negatively.
In the meantime, fears about the European financial sector have increased. Hypo Real Estate, a large German real estate company and DAX listed company, would have collapsed had it not been for a government-orchestrated bailout. A €30 billion rescue package hastily put together collapsed over the weekend when an audit revealed that the short term funding requirements were substantially higher. By Sunday night, a new rescue package was put together. In Europe, not all cash is the same, either. The short-term money markets are seized up, only government securities issued by select Northern European governments are in demand; in Switzerland, for the second week in a row, T-Bills (other countries also issue T-Bills in their domestic currencies) were issued with 0 yield, resulting in a negative yield for any participant that had to pay commissions. In our view, though, the European Central Bank (ECB) has been prudent in not lowering interest rate to date; as of October 6, 2008, short-term rates have remained at 4.25%. This gives the ECB far more ammunition than the Fed to help the crisis. ECB President Trichet has re-iterated many times that they are exclusively focused on price stability and will not lower rates merely because of an economic slowdown. However, because interbank lending rates have soared, the ECB now has substantial leeway. Just as Trichet said in 2004 that monetary policy was not tight because credit was easily available, he can now lower rates without causing inflation because - even with lower rates - access to money is likely to remain relatively tight.
A major driver in all markets, including the currency markets, has been the at times violent unwinding of leveraged positions held by hedge funds. Multi-billion dollar hedge funds need to liquidate positions, partially to meet redemption requests (according to media reports, some of the largest funds had negative returns in excess of 50% in the first three quarters of 2008), partially to reduce counter-party risks. AIG, the bailed out U.S. insurance giant, for example, was the guarantor to many financial instruments, including some London based commodity exchange traded funds (ETFs); in the weeks before AIG's collapse, in our analysis, hedge funds unwound 'long inflation'/'short financial' trades, causing seemingly erratic actions in the market. On Monday, October 6, 2008, the yen surged 4% versus the U.S. dollar while the Australian dollar fell by over 6.5%; such extreme action is a clear indication of an unwinding of the popular 'carry trade' where hedge funds had borrowed money cheaply in yen to buy higher yielding currencies, such as the Australian dollar. Volatility is the enemy of the carry trade as leverage of 30:1 or even 100:1 is the norm rather the exception for such trades. A day later, Australia's central bank has lowered interest rates from 7% to 6%, which further reduces the attractiveness of the carry trade. Another suggestion that hedge fund liquidation is contributing to the volatility is the intra-day rise of the shares of Volkswagen, the German carmaker, of 55% on October 7, 2008; the carmaker did not reinvent the wheel, but a short-squeeze must have caused the massive rally. For the global deleveraging to succeed, we must see this type of action because hedge funds are one type of leveraged player that must be brought to its knees.
In our analysis, we have not seen the end of the crisis; we expect continued volatility in the days, weeks and months to come. While we have been critical of U.S. institutions for not acting fast enough, there is progress. The remaining large financial institutions may be too large to fail; institutions from Bank of America to Citigroup; from Goldman Sachs to General Electric have been swallowing tough medicine to strengthen their respective balance sheets in a market when capital is expensive. In Europe, financial institutions still have a lot of work ahead of them; however, it does look like European governments are waking up to the seriousness of the situation. Without passing judgment whether bailouts should have taken place, European governments have shown both will and ability to act. What makes us more positive about Europe than many is that, ultimately, European economies are less fragile because of - with some regional exceptions - much healthier consumers and less elevated home prices. European governments may also be more willing to nationalize banks or force capital injections to protect the system than U.S. regulators are. Ultimately, it is capital that is missing more than anything; and then there's the value of homes that triggered all of these - in the U.S., home prices continue to be too expensive, posing further risks to the U.S. economy and the dollar. Finally in Asia, while Japan is ironically shining, the region has yet to see the full impact of weaker sales to the U.S. and potential shocks to their real estate markets.
We don't have a crystal ball either. But being active in parts of the money markets both domestically and abroad, we are concerned at what we see. There is a significant risk that the U.S. dollar resumes its downward trend. As a result, investors may want to consider diversifying to take this risk into account.
Axel Merk is manager of the Merk Hard Currency Fund and the Asian Currency Fund. To learn more about the Funds, or to subscribe to their free newsletter, please visit www.merkfund.com.