Chart provided by APEX
Credit Crisis
There are some estimates that global write downs, due to losses in the credit markets, could be as high as $1.3 trillion. This is substantially more than the International Monetary Fund’s estimate of $945 billion. One money manager said banks are only “one third through” their credit related write downs. The president of the Federal Reserve Bank of Minneapolis said in an interview that the credit problems in the U.S. markets may get worse.
Even though recent earnings reports from some banks have been better than expected, there is a growing feeling that there will be more problems in the industry within the next one to two years. Our analysis suggests that there are more subprime related problems to be revealed later.
Federal Reserve Help May Not Be Enough
Actions on the part of the Federal Reserve suggest there are more subprime related banking problems brewing. This was made clear when the Federal Reserve announced they were infusing an additional $200 billion into the banking system in attempt to restore confidence in banks that have been hurt by mortgage related write downs. The Federal Reserve said they will lend Treasury securities to troubled banks in exchange for mortgage backed securities that have lost much of their value. A good portion of this distressed paper is directly due to homeowner mortgage payment defaults. By lending Treasuries in exchange for mortgage backed securities, the Federal Reserve will let banks exchange debt that is less liquid and less desirable for Treasury paper. Within the plan, the Federal Reserve will lend Treasury securities for 28 day periods to at least 20 institutions. On the condition of anonymity, a Fed official said the program could be expanded as needed. This plan was announced after it had become more obvious that other measures they had taken to limit the impact of the credit crisis had failed to have the intended result. Some traders are saying the Fed’s rescue plan may have been a pre-emptive strike to alleviate the fallout from a possible new bankruptcy announcement.
There were additional clues to the increased probabilities of additional write downs at financial firms when the Federal Reserve more recently announced that they were expanding their Primary Dealer Credit Facility. It introduced an 84 day Term Auction Facility, which would be in addition to its existing 28 day loans. The Fed also increased their swap line with the European Central Bank to $55 billion from the previous $50 billion. This news was a clear sign that there are more banking write downs yet to be reported.
U.S. Economy Remains Weak
This Wednesday’s release of the Fed’s “Beige Book” on the economy showed that their outlook was a little more pessimistic than many analysts had predicted. They said business conditions across most of the U.S. were “slow” last month. This report was based on information collected on or before August 25Th. Although their commentary was by no means encouraging, it was not quite as negative as the previous Fed’s “Beige Book.” That report was the weakest ever published in light of the 97 references to “weak, weakness, weaker or weakening,” versus the 20 year average of only 35.
The manufacturing situation is not encouraging either after the Institute for Supply Management Manufacturing Index was 49.9. The 50 level is thought to be the line of demarcation between expansion and contraction.
The corporate earnings outlook appears to be deteriorating as well. We are already hearing reports that analysts are revising down their estimates for third quarter earnings.
There is the growing feeling that the global credit crisis will slow construction spending and economic growth in the U.S. for another year and a half. The U.S. housing industry continues to soften and it was reported that new home sales fell to near their lowest level in 17 years.
Demand for U.S. architectural services continues to decline, according to the American Institute of Architects. This leading indicator of the construction industry suggests further pressures on the economy into 2009.
In addition, the CEO of a large U.S. steel producer said “we have not seen the worst impact on the economy yet.”
Overseas Economy Abrubtly Turning Soft
Economic reports in the euro zone showed declining numbers for retail sales, exports and business investment. Retail sales in the euro zone fell .4% in July from June, when a .1% increase had been expected. Capital expenditures by corporations dropped 1.2%, which was the first decline in five years.
U.K. consumer confidence remained near a four year low in August. It was also reported that that mortgage approvals in the U.K. remained near ten year lows. A separate report showed home sales fell 9.6% in August from a year ago, which is the most in twenty years.
Japan’s economy is weakening, as GDP and manufacturing numbers point toward recession.
The Fed's Dilemma
The Fed is walking a fine line between talking tough on inflation, while not indicating that a near term interest rate increase is imminent. They are fighting a two front battle and they only have the resources to fight one. They can either support the U.S. dollar through the use of a hawkish interest rate policy or they can support the economy and the stock market through accommodation and lower interest rates. Currently, they have chosen to fortify the U.S. dollar through the use of tough talk on the inflation fight. This appeared to have at least temporarily worked, since the greenback was able to substantially advance from its July lows. However, what is the cost when the state of the economy and stock index futures are taken into consideration? Threats of higher interest rates or actual higher interest rates from the Fed are exactly opposite to what is needed in an environment of economic weakness and lower stock prices.
Our studies suggest that there will be no near term increase in interest rates from the Fed and, as the economy continues to weaken, there will actually be mounting pressure on the Fed to reinstitute a more accommodative policy stance. We remain very much in the minority when we say a weaker economy, along with a lower stock market, will force the Fed to consider lowering interest rates. While almost all other analysts are predicting the Fed will raise interest rates later this year, our work suggests that late this year the consensus will change from expectations of a more restrictive Fed policy to one of more accommodation. Expectations for tighter credit from the Fed have steadily declined over the past few months as the economy overseas and in the U.S. continues to weaken. Financial futures currently have factored in a 14% chance that the Federal Open Market Committee will raise the fed funds target rate by 25 basis points to 2.25% before the end of 2008. Most likely, as we get closer to the end of the year, market expectations for a rate increase will diminish.
Higher Futures Prices Are Likely
I have received many questions lately pertaining to upside price objectives for the interest rate futures. My analysis tends to focus on timing objectives rather than on price objectives when a major market move is taking place. However, once our timing objective has been met, whatever the level of eurodollar futures is at that time, will be the price objective. Continue to trade eurodollars from the long side as the pressure on the Federal Reserve to lower interest rates intensifies. In addition, we are expecting eurodollar futures to gain on the 10 year notes and on the 30 year bonds. Expect higher prices for eurodollar futures, at least through the first half of 2009.
Questions or comments about this article, please contact Alan at 1.800.243.2649 ext 7911 or email at alan.bush@archerfinancials.com .
Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. The views and opinions expressed in this letter are those of the author and do not reflect the views of ADM Investor Services, Inc. or its staff. The information provided is designed to assist in your analysis and evaluation of the futures and options markets. However, any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to ADMIS. Copyright © ADM Investor Services, Inc.
