USD: What Does TARP Mean for FX?

In this note we consider the details of recent US initiatives to deal with the financial crisis as well as implications for financial markets, including currencies.

It now seems highly likely that the USD 700bn TARP (Troubled Asset Relief Program) will become a reality after weekend negotiations resulted in a deal between US government and Congress. Relative to the original plan, the revised plan includes restrictions on executive pay as well as increased oversight of the Treasury. It also mandates the Treasury to take an equity stake in the companies that benefit from TARP, probably in the form of equity warrants. Somewhat unclear is a plan to reduce foreclosures which was not in the original plan. We expect the overall plan to be presented for a vote in the House on Monday and in the Senate on Wednesday.

What is the impact of TARP?

We see TARP as part of a proposal for a systemic way of dealing with the financial crisis that consists of several different parts.

The first is TARP itself. The main purpose is to provide liquidity to lenders by letting the Treasury buy as much as USD 700bn in mortgage-related assets. The initial, immediate endowment is USD 250bn, which can be raised by USD 100bn following a Presidential report to Congress. The President can then ask for the final USD 350bn, unless Congress votes specifically to withhold the money. TARP will operate through reverse auctions, where a key feature will be to increase transparency on mortgage assets, presumably also allowing external parties to bid. Relative to outstanding mortgage debt, TARP should be big enough to have a meaningful impact (non-GSE mortgage debt is USD 5.6trn with delinquency rates of 5-6% so USD 700bn is indeed a considerable amount). Details on eligible securities under TARP remain patchy, and although the Treasury can probably start buying linear securities straightaway, it may take a while before structured products can be auctioned.

The second is a plan under TARP legislation to allow the Federal Reserve to pay interest on bank reserves held at the Fed immediately rather than from October 2011, which was agreed under the Financial Services Regulatory Relief Act of 2006. By paying interest on reserves, the Fed can establish a floor for interest rates (thus potentially preventing the recent collapse in T-bill rates), and if necessary initiate a quantitative easing of monetary policy to stimulate the economy.

The third is the substantial initiative to support money market mutual funds. Here there are three actions: one consists of non-recourse loans to depository institutions to buy asset-backed commercial papers from money market funds, another lets the Fed buy agency discount notes and the final is the deposit insurance guarantee to money market funds from the Treasury by way of the Exchange Stabilisation Fund. Money market funds have assets of cUSD 3.4trn and are central to corporate financing.

The fourth is another round of liquidity from the Fed. Recently we have seen the Fed increasing the list of collateral in the primary dealer credit facility and the term security lending facility (TSLF). We have also seen an increase in size and in frequency of the TSLF. And finally, banks have been allowed to move liquidity back and forth to non-bank affiliates.

And the final one is the recent ban on short-selling by the SEC.

The purpose of TARP as well as the other parts is to separate performing from troubled assets, slow financial deleveraging and reduce the risks of not just a systemic run on banks and money market funds, but also reduce the risk of an economic hard-landing. It is not a given that the plan will work. The whole point about transparency and price discovery is a bit vague, and among other things increases the risk of exposing additional bank losses. But it is probably a safe bet that even the first USD 250bn will go a long way in increasing liquidity in mortgage-related debt products these days.

The rescue package is not a general bank bailout, so bank lending is likely to be under pressure for quite a while just as further bank failures can be expected. Neither does the plan address consumer credit or commercial real estate debt.

What are the likely economic and financial implications?

To begin with one can try and put TARP into the perspective of the US budget. The forecast for the US budget deficit in 2009 after the other rescue packages to date in 2008, including the GSE package, is roughly USD 650bn (4.4% of GDP). TARP will not be treated as an outlay, but rather as a loan, in a similar way that student or farmer loans are treated. It seems to be a common misunderstanding, but the US deficit will not just increase by USD 700bn. (It is perhaps highly ironic that the rescue package in that way will be off-balance sheet – or at least off-budget).

However, assets purchased have to be funded so if public spending isn't reduced by other means (which seems highly unlikely considering the economic downturn), then the primary funding requirement for 2009 will be USD 650bn + USD 700bn or USD 1.35trn (c10% of GDP). Debt to GDP will thus rise a good deal. But in the long term (five years) it is not at all impossible that TARP will make money for taxpayers as assets are sold. A conservative estimate puts TARP at breakeven after five years, with no negative implications for US debt ratios. All of this is highly uncertain.

The third point is that money is not created by TARP, that is, there is no impact on money growth. There is simply an exchange of debt between two economic entities. This also suggests that TARP in itself should not be inflationary. There was a jump in US breakeven inflation rates immediately after the presentation of TARP, but it is not obvious that the increase in expected inflation should be sustainable, unless we begin to factor in a different economic scenario.

In terms of market impact, key points are:

First, risky assets should be able to stage a rally on this. If the overall package is not seen as contributing to a solution to the financial crisis, then it is very hard to see what might. Equity markets should be able to stage at least a bear market rally, taking S&P500 back up to the recent high of 1300 (up 7-8% from here or 12% from the recent low). This rally is probably being held back until TARP passes into law, and until the final details on eligible assets become clearer, but it is also being held back by new losses and defaults in the financial sector in Europe.

Second, buy what the Treasury is buying (mortgage debt) and sell what it is selling (Treasuries). We still don't know how increased Treasury issuance will be financed, but one can assume that if the impact of TARP will be paid back in five years, then funding should be concentrated in the front end of the curve.

Third, in currency markets we should be able to see at least a modest rally in risk as well. The recent carrydrawdown has been exceptionally sharp, with a G10 carry index down more than 10% since mid-July. The problem with positive carry strategies these days, however, is that we still expect leverage to shrink and most of the high-yielding currencies are still in the midst of cyclical slowdowns. But in any case, JPY net longs and AUD shorts are likely to be reduced.

Finally, we believe the impact on the US dollar is mixed. One line of reasoning is that since we are seeing a fiscal easing, the increase in the supply of Treasuries should result in higher yields and a weaker dollar to compensate foreign investors for increased risk. This is known as the portfolio balance approach to currencies. But the theory assumes a link between FX and long-term real rates of interest that can be highly unstable. Further, the net impact on US public finances in the medium term is not necessarily negative and even in the short term we are looking at an exchange of debt rather than in an increase in overall debt. So even from a portfolio approach, the net impact on the dollar could be positive as overall interest rates decline.

An alternative way is the so-called Mundell-Flemming model, where the impact of a fiscal easing on a currency depends on the related response by monetary policy. If, and that's a big if, the Fed is leaning towards higher interest rates relative to market levels, then the combined effect could also be positive for the dollar.

In real life, we believe two effects should dominate. First, a better performance of risky assets should result in a reversal of the flight to quality the USD enjoyed in September. But judging from a shift in positioning as well as in risk reversals in options markets, this has to a certain extent already materialised. Second, the rescue package should help the US economy recover in 2009, all else being equal, presenting a positive impact on the dollar.

Further, we need to take into account what is happening outside the US. Europe is on the brink of a recession, and there are still only scant signs of efforts to deal with the financial crisis here. Japan is slowing sharply as well, as are many emerging markets. US policy initiatives are placing the USD in a better position to perform than most other currencies, particularly given its general undervaluation.

The result could be to see USD/JPY trade higher with equity markets (which will also weigh on CHF), but to keep EUR/USD in a range for now. Looking into 2009, we continue to believe in a further decline in EUR/USD.

Danske Bank
http://www.danskebank.com/danskeresearch

Disclaimer

This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets´ research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright (©) Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.