The response was needed because conditions were dire. Conditions are still dire.

Foreign Exchange Currency Outlook : We are very happy to see the Treasury and Fed taking a vigorous initiative. We are even happier that it’s a comprehensive approach to “systemic” risk and not the one-by-one approach of the past few weeks. A lot has happened in just two weeks, the failure of Freddie and Fannie, Lehman, the break-the-buck money market fund, and questions about Morgan Stanley (about which the Chinese may feel “it can solve its own problems,” according to one report today).

The market is happy to see such a vigorous response, too. With stocks rallying everywhere and the US dollar reversing direction, things sure look good today.

But wait a minute.

The response was needed because conditions were dire.

Conditions are still dire.

The rescue plans have not yet been tested and found sufficient. What other terrible thing can happen that is not foreseen today? While nobody expects Congress to pull back from any of the plans, the fact remains that the government is about to commit to nearly $1 trillion of money that it doesn’t actually have. Unlike the Resolution Trust situation, where the government had already seized the S&L’s, this time the government has to go out and buy the toxic assets from the current holders. Nobody knows what the price is or should be. Sounds like Russia when it opened markets for the first time… and the oligarchs began to emerge, the very essence of crony capitalism. This problem will become severe as buyers start to emerge. Will there be favoritism? Just as some make a fortune on short-selling before the SEC finally stopped it (and note that the ban on short-selling ends in Oct-and Jan in the UK), are some players getting preferential treatment?

This is a nightmare of imputed sovereign risk.

And what will be the price and yield of the new paper the US will have to issue to backstop the new entities and plans? As we wrote yesterday, the US will have to pay a premium to get the money. Rising yields are usually good for a currency but you have to consider the context. The US is forced to sell paper but buyers are not forced to buy it (unless the State Dept is twisting arms behind the scenes in China and the Middle East, which wouldn’t surprise us at all).

In short, it’s still a crisis and it’s a crisis home-grown on American soil.

It’s a little premature to say the dollar is going to come out of it unscathed. Watch gold (and as always, oil) today. If the recessionary tendency (and deflationary tendency) proceed as expected, oil should resume its decline and that is US dollar supportive. But if fear is not banished, gold will hang on to gains. It’s a symbol, perhaps, not an asset class into which intelligent people put capital, but still—it’s not without meaning. Be still feel quite fearful. We doubt the dollar can make a full recovery—but it’s still early, and we have a lot of confidence in the brainpower and willpower of Bernanke and Paulson. At a guess, we will want to go into the weekend square, unless the chart shows something compelling after the close today.

Friday’s are important.

Bye for Now

Barbara Rockefeller

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