US Sneezes

Yesterday, we wrote that when the US sneezes, the rest of the world still gets a cold.  Now there are reports from DailFX.com comparing the Asian financial crisis of 1997-98 to the US subprime fiasco.  But while the starting points may be similar, there is reason to believe the reactions by international central banks will be different.

In 1997, traders and investors were highly leveraged in risky investments in emerging markets in Southeast Asia.  When the Thai government floated the baht, all hell broke loose.  In the current situation, traders and investors were highly leveraged into complex debt instruments backed by risky mortgages.  When foreclosures reached record highs, the credit market went into a state of panic.  If the parallels continue, then we should be looking at multiple interest rate cuts by the end of this year.

But the major difference in this case is that Fed Chairman Ben Bernanke has proven different than his predecessor Alan Greenspan.  Bernanke seems to be less inclined to bail out investors suffering in times of falling markets, especially if that bailout would include an interest rate cut.  Recent reports on Bloomberg indicate that the Fed has not decided on a course of action with regard to interest rates, instead hoping to give the increased liquidity time to work and the market time to digest the effects of the discount rate cut.  Senator Chris Dodd, Chairman of the Banking Committee, even pressed last night for more banks to take advantage of that rate cut.

That comment took place after a meeting with Secretary of the Treasury Henry Paulson and Chairman Bernanke.  The meeting was important on a number of different levels.  It occurred amid a backdrop of hawkish comments by a couple of Fed officials.  Futures traders, who had priced in a 100% chance of an interest rate cut in September, dropped their projections after the meeting to a 50% chance of a rate cut.  But one analyst for DailyFX.com still regards it as almost a certainty that the Fed will lower rates by at least 25 basis points (and maybe even 50) during their meeting on September 18.

The interesting thing about this scenario is that even in the midst of all these problems in the credit markets, the broader economy is still doing well.  Fundamentally, US growth remains on track, above the standard 2.0% level.  Unemployment remains low, and inflation seems to be relatively contained.  Even the debt market appears to be balancing itself out, as yields have begun to bounce back (the Fed is even considering accepting commercial paper a collateral for its discount loans).  Volatility is retreating, with the VIX down 30% off its 4-year highs last week.  Equities trades might cry foul, but the best decision right now might be to leave the Fed Funds rate unchanged.  And at least with regard to the foreign exchange market, that is good news for dollar bulls.