What Does Fannie/Freddie Rescue Mean for FX?

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FX Market Outlook

After last week's insane volatility that saw extended periods of time when cable and euro were trading 15 wide at the interbank level with prices jumping 30 points a tick, we hoped that this week may bring some much needed calm and stability to the currency markets, as the unwind in commodities, the collapse of carry and the one way action in the dollar would all come to at least an pause.

No such luck.

Late Friday evening, news started to leak out that US Government will be taking control of Fannie Mae and Freddie Mac assets, by placing the two companies into a receivership. US taxpayers have just agreed to guarantee $7 Trillion of mortgage paper and no one even asked them. In truth the majority of those assets remain functioning, well performing loans but because of the paltry capital base of both Fannie and Freddie, even tiny problems in the portfolio will necessitate infusions of billions of dollars into the two companies balance sheets.

The current plan is to pay-as-you-go, limiting large initial outlays by injecting approximately $50 Billion into the companies each quarter as needed. How much money will this total to at the end?

No one has clue.

What does this mean for the currency market?

Again, no one has clue, but we'll try to offer our initial assessment.

The initial reaction post news was effectively dollar bullish against the low yielders as USDJPY and USDCHF spiked up about 50 points in week-end trade. The thinking goes that the move will avoid the collapse of the two pillars of US financial markets and will in effect eliminate the systemic risk that has plagued US capital markets since the start of the credit crunch. The question however is whether this action will truly mitigate this risk or simply postpone it. One thing appears certain to us. The speed and brutality of this policy move suggests that the real fears of US officials had more to do with the health of Treasury financing rather than the well being of the housing market.

China is one of the largest buyers of US government securities providing much needed capital America which runs $1 Trillion Current Account annual deficits. In a move dubbed Bretton Woods II - the parties have essentially agreed to an implicit compact where US would provide open access to its markets while China would recycle its export profits into US government paper. This arrangement worked exceeding well for most of this decade until the housing collapse created massive losses in mortgage backed securities.

According to the latest data the Chinese owned more than $300 billion of Fannie Mae and Freddie Mac paper. The notion that this investment may actually be subject to capital losses and possible default risk did not sit well with authorities in Beijing. Treasury Secretary Paulson who in his former post as chairman of Goldman Sachs, knew the Chinese intimately, visiting the country more than 50 times during his tenure there, was no doubt concerned that any uncertainty vis a vis the Fannie/Freddie issue could create much larger issues in US capital markets. The move this week-end is in effect the rescue of the Chinese portfolio and the hope that capital spigot from Asia remains open and available for future US financing.

There are, however, some very serious problems with this scenario. The Chinese economy while still growing as a healthy pace may be in for brutal slowdown, as global demand from G-3 cools considerably and the country wakes up to its post-Olympic “hangover” which has resulted in a recession in every host nation in the post war period with exception of 1984 LA. Already Chinese PMI manufacturing surveys have shown contraction for two months in a row - and while the optimists argue that the decline is due to a mandate of pre-Olympic factory shutdowns - we remain skeptical that it is the only factor for the slowdown in activity.

On the US side the latest unemployment data suggests that demand is unlikely to revive soon even as oil prices recede from their stratospheric levels. The US consumer is caught in a viscous cycle of facing higher prices at the store and scarcer employment opportunities at work. Therefore, any relief at the gas pump will likely be funneled into savings or reduction of debt rather than additional spending. This dynamic, in turn suggests that US economic activity will slow in Q4 resulting in less tax revenues and thus greater demand for deficit financing.

What does this mean for FX? First and foremost we continue to believe that the idea of a Fed rate hike any time in 2009 is pure fantasy. US rates will likely remain at 2% for this year and the next and may even be lowered to 1% as US follows the Japanese down the deflation stairway. Under these conditions we continue to believe that the low yielding yen and franc will outperform as risk will be shunned in the markets more than Michael Moore at the Republican National Convention.

Of course the Panglossian view may triumph. The move this week-end may indeed provide a bid for financial assets, global growth could recover fueled by lower energy prices and risk and credit expansion will once again follow. We will, as usual, try to let the facts dictate our view, but for now we see the Fannie and Freddie move as sign of weakness rather than a sign of strength and expect any positive reaction to be short lived.

Trading Thoughts- Luck or Skill?

The lead from the Guardian was relatively nonchalant. In a very matter-of-fact way it noted that “Hedge fund manager Ospraie Management LLC will close its flagship fund after it plunged 27 percent in August on losses in energy, mining and natural resources equity holdings, in one of the biggest ever closures of a commodities-focused hedge fund.”

Staring at that sentence on the screen , however I was stunned. Ospraie wasn't just some wanna be player in the hedge fund world. It was the creme de la creme of commodity money managers. Featured in the House of Money - a seminal book on the stars of the hedge fund world - it enjoyed a golden reputation as a savvy trader of hard assets.

And yet these guys blew 27% in just one month. The reasons for their demise do not matter. Clearly they simply did not manage their risk. In fact they confirmed my suspicion that the money management strategy of most hedge funds is to double down when they are wrong and hope that they have enough capital to weather the storm. Sleek skyscraper offices, richly textured brochures, soothing talk about Phd driven risk control models are all nonsense. Most hedge funds are horrible traders. In fact if all hedge funds had to reveal their trading positions in real time like we do at BKT 99% of them would probably be out business.

Hedge funds hide behind the mystique of competence but the longer I am on Wall Street, the more I am convinced that Nassim Taleb is right - most successful people in finance are simply lucky and are only one bad trade from blowing up your money. There are only two traders that I know of who are truly great - Paul Tudor Jones and Steve Cohen. Both are traders frist and foremost. Both will always take a stop when they are wrong. Both have had more than 200 months of positive returns with only one or two months of negative performance of no more than -1.5%. In fact, if there is a single question that I would ask a hedge fund, would be this - What was you worst monthly performance? If they say 10% or more - run from their office and don't even bother listening to rationalizations.

The Osprie saga only serves to remind us just how difficult this business can be. But it is also a testament to the BS that permeates Wall Street. Making money consistently is not easy and most managers are simply lucky rather good.

Boris Schlossberg
BKTraderFX