LONDON (ResourceInvestor.com) -- It is an interesting, even historic, time for Wall Street. Lehman Brothers has filed for Chapter 11 bankruptcy protection, while Merrill Lynch seems set to be acquired by Bank of America in what is as much a rescue as anything else. The landscape of the U.S. financial system is set for more sweeping changes, following on from the collapse of Bear Stearns earlier this year. The credit crunch has claimed more victims from among the big names of the investment banking world.
It seems that no-one has yet seen value in Lehman Brothers, which is suffering from toxic positions in the sub-prime mortgage sphere as well as the more general atmosphere of chaos in financial markets. Korea Development Bank walked away from discussions on the possibility of buying Lehman Brothers last week, and the U.K.'s Barclays Bank has now done the same. After all, the Lehman brand has dubious value. Would you trust an investment bank that can't even look out for its own survival?
Against this backdrop, tomorrow the Federal Reserve must decide what to do about interest rates. The consensus seems to be that U.S. rates will remain on hold. There is always a chance that the Fed will cut rates in order to help alleviate the intense pressure on the financial system that this week will see, as well as the travails of the wider economy. At the same time there remains a faint possibility of a rate increase, which would combat the still potent inflationary threat, but would do nothing to aid Wall Street in its adjustment to the new financial landscape or help out U.S. consumers as their stimulus cheques become a distant memory; and is therefore considered pretty unlikely.
Where does all this leave the dollar? Leaving rates on hold offers no additional support to the greenback's rally, which the Fed is relying on to go some way towards tempering inflation, while a rate cut would be pretty bearish.
The Fed also has to bear in mind the dollar-negative implications of the recent decision to take Fannie Mae and Freddie Mac into conservatorship at a cost to the U.S. government of hundreds of billions of dollars, and those of the economic stimulus package, which cost a similar sum.
As if that wasn't enough, the dollar will have to deal with talk that China is to cut the proportion of its foreign currency reserves, which amounted to in excess of $1.8 trillion at the end of June, held in U.S. dollars. This has the potential to set off a seismic currency market shift and to inspire copycat moves by other large holders of U.S. dollars, such as the other central banks of industrial East Asia.
The issue of Chinese reserve diversification isn't new. I last covered the topic , in November 2006. Although the dollar has fallen since then, the decline has been pretty orderly. But sooner or later the unthinkable may actually happen and there will be a run on the U.S. currency, which would have serious global implications, such is the key role still played by the greenback in the world financial system, as well as being deleterious for the U.S. economy.
It is also worth remembering that the U.S. trade deficit is still egregious and substantially exceeded forecasts during July, in large part due to higher oil prices and increased imports from China. But it served as a reminder that the dollar will eventually have to fall further if, as the talk out of China referred to in previous paragraphs suggests, the willingness of the rest of the world to finance a persistent U.S. trade deficit of such magnitude is waning.
Nevertheless, belief in the underlying weakness of the dollar has been shaken lately. The dollar has rallied since July, and funds have poured out of euros and out of gold in response. But sooner or later the situation will reverse as reality reasserts itself, and once the dust settles, the unfolding Wall Street shakeout may be the catalyst that is needed.
