Aug
22
TWo contrasting views on the crisis
In this piece , we present two contrasting views on whether the crisis is nearing its end-game stage. Strategists at Morgan Stanley expect some spill-over into the real economy but they believe the financial crisis is close to over. In contrast, HSBC points out that the excesses were a long time in the making and expects the unwinding in the financial markets still has some way to go:
HSBC - Currency Weekly (Aug 20)
The spreading financial market hurricane hit the FX market with full force last week, before the Fed discount rate cut helped reverse some of the moves. It is tempting to conclude that these dramatic moves constitute a final ‘blow off’ which signals the last phase of the market ‘crisis’. However, there are good reasons to believe that there is more to come. Although implied volatilities are much higher, they are still some way below average levels seen in 2000 and 2001, yet alone the peaks of 1998. More importantly, the rise in implied volatility has been synchronised across FX, equity and fixed income markets in a way that has not been seen since 1998. The market turmoil has its roots in the unwinding of leveraged risk positions accumulated over a long period. The benign environment of rising asset prices, narrowing spreads and declining volatility developed progressively, with only modest reversals, from 2003 until June this year. It would be very surprising if there has yet been enough time for the unwind to be complete. In the short term, the Fed’s actions will probably mean calmer conditions in the market, and some recovery for the high yielding currencies. However, the current situation is arguably more serious than 1998 because many of the instruments used are more complex and opaque, and there has been a longer period of quiescence in which these positions have been built.
The relative calm at the beginning of this week may well persist for a short while, but the underlying change in the market – the re-pricing of risk – is a major structural change that will take some time to work its way through. Uncertainty over central bank policy intentions is also likely to remain high as the policy makers have to assess the extent to which market developments will feed back into economic performance. The longer term risks are for persistent higher volatility, and more strength for the yen and Swiss franc at the expense of the dollar and the high yielders. Also, the current corrective tone in the G10 high yielders is likely to be short lived and limited as further de-leveraging takes place.
Morgan Stanley - Global Economics (20 Aug)
Global softening is in the price, but global recession is not. Therefore, near-term weakness in US consumer spending could ignite fears of global economic contagion. In contrast, if market functioning returns, investors should not count on additional aggressive Fed action, much less succor from other central banks. Investors should not lose sight of the global economy’s underlying resilience, which could play an important role in reversing the downside risks for markets.
Morgan Stanley - Currency Economics, Stephen Jen (Aug 20)
Bottom line: (1) The surgical strike by the Fed last Friday is an important turning/inflection point, in my view, i.e., this is the beginning of the end of the financial crisis. Though I have been surprised by the violence in the financial markets, and am now expecting some collateral damage to be inflicted on the real economy, I continue to believe that risk-taking should eventually recover and that the robust global economy will shake off this shock from the financial markets. (2) Modest downside risks to growth in the US are clear, working through the channels of lower consumer wealth, the Tobin’s q effect, a higher cost of capital and a general hit to confidence. For the rest of the world, weaker US consumption, more moderate capital inflows and lower oil prices are the three key variables to consider. For some countries (e.g., China and Australia), a prospective slowdown in the US would be welcome, but for others (e.g., India, Turkey, South Africa and New Zealand), a decline in international risk capital flows could pose a policy challenge. An important offset is, of course, the ample ability of virtually every central bank in the world to either stop tightening or outright ease. (3) Among all the possible scenarios for the global economy and the Fed’s possible actions in the coming months, I think that the most likely scenario is the US re-entering a soft patch, with minimal negative effects on the rest of the world (i.e., economic de-coupling). This, in turn, means that, starting with a narrow global output gap, any easing by the Fed will need to be retracted soon, in order for the world to avoid broad-based inflation in 2008/09, which to me is the bigger worry rather than the sub-prime problem or de-leveraging. (4) For the currency markets, I am looking for a partial reversal in the trends we’ve witnessed in the past month, led by JPY weakness and AUD and NZD strength, as general risk-taking appetite starts to recover.