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More Action Needed

(November 6, 2008)

Dear Subscribers and Readers,

As I have discussed over the last few months, both the Bank of England and the European Central Bank have been way behind the curve in their monetary easing campaigns.  Prior to the October 8th global coordinated emergency rate cuts, I had estimated that both central banks were about 150 to 200 basis points behind the curve – as the global economy was sinking into a deflationary spiral.  Today, the Bank of England delivered a shocker to the markets by cutting its policy rates by 150 basis points.  Consensus was for a cut of just 50 basis points.  More significantly, the British Pound bounced back from its initial 1.1% loss against the U.S. Dollar, signaling that this cut was the right move and that positive impact of this cut on the UK economy should outweigh the narrowing interest rate differential between US/Japanese and UK rates.

Soon after the Bank of England's larger-than-expected cut, the Swiss National Bank followed up with an unexpected 50 basis-point cut in its target rate (3-month LIBOR) from 2.5% to 2.0%.  This should bring further relief to the overall European financial system, as many companies and citizens in Europe (particularly Eastern Europe) have been engaged in the Swiss Franc carry trade over the last five to six years.

Unfortunately, neither the Bank of England nor the Swiss National Bank is the “800-pound gorilla” in the global financial system.  Following the Bank of England's larger-than-expected cut, many investors had hoped that the European Central Bank would follow up with a larger-than-expected cut just minutes later – with global market index futures rallying in anticipation.  After the European Central Bank revealed that it was only cutting its policy rate by 50 basis points, global markets retreated back to near its worst levels of the day, with the S&P 500 plunging by nearly 20 points immediately after the ECB's cut.  While I expect the ECB to cut again later this year, this latest 50 basis point “incremental” rate cut was deeply disappointing.  Make no mistake: The 800-pound gorillas in the financial system are still the Federal Reserve, the European Central Bank, and the Bank of Japan.

Speaking of the Federal Reserve and the US financial system – now that Barack Obama has won the Presidential election – it is now time for him to assemble his cabinet.  To investors, the three most important things to watch in the immediate term are: 1) Obama's selection as his Treasury Secretary and Chairman of the Council of Economic Advisors, 2) More clarification on his economic and tax policies, and 3) More clarification on his alternative energy and other scientific polices that could pave the way for sustainable long-term economic growth not just in the US, but around the world as well.  On point 1), word is that the top three candidates for the role of Treasury Secretary under an Obama Administration is Tim Geithner of the New York Fed, Lawrence Summers, former Treasury Secretary under President Clinton, and Paul Volcker, former Federal Reserve Chairman.  My sense is that Volcker is "out of the race" given his age and ideological differences.  However, I still expect Volcker to continue to serve in an advisory role under Obama, especially during times of financial instability such as what we have been experiencing over the last 18 months.

I also do not expect Lawrence Summers to be appointed – given Obama's slogan of “Change” and given Summers' disappointing legacy at Harvard University.  In my mind, the top candidate is Tim Geithner, as he has more than proven himself as head of the New York Federal Reserve branch over the last 18 months.  More importantly, Geithner is regarded as one of the most dovish Fed governors in modern Fed history. He has also worked with Ben Bernanke in a great capacity since the current crisis began 18 months ago. If he is picked to be the Treasury Secretary, I expect the Bernanke-Geithner combination to simply “let the printing presses rip” – that is, to further ease monetary and fiscal policies by expanding the Fed's balance sheets, helping to recapitalize more financial institutions or further expanding the Fed's “helping hand” to non-financial institutions, and providing more liquidity to global financial markets by enlarging current swap lines with other central banks or even purchasing foreign sovereign debt on the open markets.

Providing US Dollar liquidity to the global financial market is still of particular importance, as many countries, companies, and retail investors alike have been heavily engaged in the US Dollar carry trade over the last few years.  A quick unwind at this stage would unleash further damage on the financial system.  Moreover, the US economy cannot afford a significantly higher US Dollar at this stage.  Despite a slowing global economy, the amount of US exports is still growing at the quickest rate in years.  The inverse relationship between the US Dollar (trade-weighted) and other “risky assets” can be seen from the following cross-correlation chart, courtesy of Goldman Sachs:

Inverse relationship between the US Dollar (trade-weighted) and other risky assets
* Click on image to view larger image

The above cross-correlation matrix is divided into an upper-right half which charts the three-month correlation and a lower-left half which charts the one-year correlation.  The color of red suggests that the current correlation is below that of its historical mean – and that the brighter the color, the further away it is from its historical mean.  For example, the current three-month correlation between the Japanese Yen and many popular stock market indices are at a “bright red” stage, signaling that the three-month correlations between the Yen and these assets are two to three standard deviations below their means.  We are also seeing similar negative readings in the trade-weighted US Dollar – suggesting that any further spikes in either the US Dollar or the Japanese Yen would be very detrimental to global stock markets.

At this point, both the Federal Reserve and the US Administration are doing everything they can to provide US Dollar liquidity to world's financial markets.  Unfortunately, despite a recent 20 basis-point cut from by the Bank of Japan (cutting its policy rate to 0.30%), the Bank of Japan has simply not kept up with the Federal Reserve in terms of providing liquidity to the global financial markets, as can be seen from the following chart showing the year-over-year change (as well as the second derivative, or the rate of change in the year-over-year change) in the Japanese monetary base versus the year-over-year change in the Nikkei 225 Index:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to October 2008) - While the y-o-y growth in the monetary base (1.4%) beat expectations (1.2%), the BOJ still has its work cut out for them, as the monetary base is still at near its October 2002 levels. More needs to be done!

For the month of October, the year-over-year growth in the Japanese monetary base jumped to 1.40% - the highest level since February 2006 and beating the expectations for a 1.2% year-over-year growth.  Despite that, absolute value of the Japanese monetary base is still near its October 2002 levels – suggesting that the Bank of Japan still has its work cut out for them.  While the upcoming fiscal stimulus from the Japanese government should help, it is definitely not enough.  At this point, the Bank of Japan will need to either ramp up its printing pressures in a more aggressive way (similar to its “Quantitative Easing” policy implemented in 2001 or directly intervene in the foreign currency market by selling the Yen.  My sense is that they will do a little bit of both in the near-term – but more action is still needed from Japan – not to mention the European Central Bank.

Signing off,

Henry To, CFA

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