Bear Stearns Tremor Warns of Earthquake in Financial Markets

Investors are suddenly wary of debt-backed assets. This begins with a deep suspicion of the most suspicious assets like mortgage-backed bonds, or the CDOs that are carried on balance sheets at values somewhat removed from market reality. But here’s the trouble when the market loses confidence - it puts an end to the bull markets in nearly all riskier assets.

Is the Australian dollar a risky asset? It depends on who you ask. But that’s where to look for the effect of a spreading global credit crunch. Investors will sell high yielding assets (bonds, currencies, emerging markets) and repatriate that money in to local bonds or short-term cash deposits. Those investors could be retail Japanese savers who’ve been buying the Aussie. Or they could be hedge funds who close down emerging market and resource bets and head home to momma, the US Treasury market.

That’s what we’ll find out in the next few weeks. The first few tremors from Bear Stearns (NYSE:BSC) can be viewed, or felt, as the warning signs of a structural earthquake in the financial markets. It could, on the way down side, bring a nasty correction. Or, seeing as how most investors prefer to preserve their capital if they can, it could initiate a migration out of debt-backed assets and into tangible assets or, on the currency side, commodity-based currencies like the Aussie, Canadian, and New Zealand dollars.

The truth is, nobody knows how an integrated world financial system will behave in the first real crisis of financial globalisation. That’s why most traders were relieved last week that Merrill Lynch did not actually try and sell its collateral from Bear Stearns and establish a market price for risky debt. Had it done so, everyone else would have been forced to establish a market value for assets that are, as everyone seems to know, worth a lot less than what they’re being carried at.

Dan Denning
The Daily Reckoning Australia

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