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The government bailout of Fannie Mae and Freddie Mac (also known as Government Sponsored Enterprises or GSEs) is the biggest story in the financial markets today - the announcement sent US equities and stocks soaring. The dollar index hit a 1 year high as the EUR/USD fell to an 11 month low. Although we are witnessing the second wave of dollar strength, with the EUR/USD falling to an intraday low of 1.4054, it is important to realize that from here on forward, additional gains in the US dollar could come at a slower pace. The government’s bailout of the GSEs will shore up confidence amongst foreign investors and in particular, sovereign wealth funds (SWF). Treasury Secretary Paulson took a look at China's $4.6 billion reduction of exposure to Fannie and Freddie debt and realized that something needed to be done to prevent a further exodus of foreign investment. There is no question that reassuring sovereign wealth funds is one of the main reasons why Paulson decided to act now and not later.
Worry…Treasury
However as much as we applaud the Treasury’s announcement, the price action in the bond markets indicate that many traders still believe that the Treasury has given the markets a band-aid rather than a cure. Bond yields skyrocketed after the government’s announcement but ended the day lower. Carry trades also gave back a good portion of its gains, suggesting that nervousness still reigns in the financial markets. Investors have a good reason to be worried because US banks and the US economy still face fundamental problems.
At this juncture it is important to remember the 3 primary drivers of the dollar’s strength – slower growth outside of the US, risk aversion and falling oil prices. None of these macro drivers have changed but instead, the dollar’s strength has brought on new trends that we will discuss in tomorrow’s Daily Currency Focus. In the meantime, since our targets in the EUR/USD and the GBP/USD have been hit, it is time for traders to consider reducing dollar long positions and look to reestablish them at higher levels.
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