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October 08, 2008

Recapitalizations - Rate Cuts - Yen becomes Hard Currency
by Axel Merk

Europe was all but written off on Tuesday when Gordon Brown, the UK prime minister announced late in the day that £50 billion (about $85 billion) may be injected into several of the biggest banks. The details known so far are that eligible banks can issue preference shares to the government; the Bank of England makes another £200 billion of liquidity available in the short-term markets; and a further £250 billion of government guarantees are issued to help banks in their funding needs. We have been arguing that recapitalizing banks is the most effective way to support financial institutions (see our analysis of the $700 billion bailout package). Just as important, however, is that a European government was able to act. The British approach may serve as a model for the rest of Europe and possibly the US as well. Already, the Italian government has indicated that they will follow suit. The reason bank re-capitalizations are so much more effective is because fresh capital may be used with leverage; with fresh capital, financial institutions are free to employ a market based solution to their bad assets. In the UK model, other than the dilution of issuing shares, there is no penalty associated with the government support. While this may draw the ire of the public, it may encourage private investors to follow suit; the reason private investors have been reluctant to provide capital to financial institutions is because, at least in the US, equity holders have been wiped out whenever the government has provided support.

We saw a coordinated rate cut around the world Tuesday morning. Central banks around the world had waited with a coordinated cut until they saw a chance that such a cut would have an impact. For that, the program announced earlier this week by the Federal Reserve (Fed) to buy commercial paper was a necessary pre-condition; the Fed may now also pay interest on deposits. These programs may help to unlock the frozen money markets; the coordinated rate cut is intended as jumpstarting these markets that have been in cardiac arrest. If the money markets are frozen it does not matter what rates the Fed is charging. The design of the commercial paper program will help but may not be sufficient as the Fed will buy directly from corporations rather than act in the secondary market; the challenge with that approach is that rather than acting as a clearing agent, the market may outsource the commercial paper market to the Fed. This is still a relief to banks that can now protect their lines of credit, but will still make money market funds reluctant to buy commercial paper as it may not be possible to sell any securities acquired; however, it does remove the "rollover risk", the risk that firms can refinance any maturing paper.

During the credit expansion, European Central Bank (ECB) Trichet had been arguing that ECB policy was not tight despite widespread criticism; his argument was that credit was easily available and the level of interest rates didn't matter as much. Using the same argument, the ECB now has leeway to cut rates without giving up its mandate on price stability. Because inter-bank lending rates are very high, the ECB's lowering of rates is merely an attempt at adjusting the market's rates to the level the ECB desires. The media spins the coordinated rate cut more as providing cover to the ECB; we believe that while the coordinated rate cut is certainly appreciated, the ECB is not wandering away from its mandate of price stability.

Indeed, by trying to stabilize the financial system in earnest now, we are moving to a new phase in adjustment of the global imbalances. In the current phase, should the governments succeed to stabilize financial institutions, we will allow an economic contraction to take place in an orderly, rather than chaotic manner. This is a deflationary force that central banks, in particular the Federal Reserve, may fight vigorously; this may cause problems down the road; gold is already signaling that this may eventually be inflationary; the dollar may follow suit versus other currencies.

A beneficiary of the current phase is the Japanese yen. The Japanese banking system appears now more stable than the banking system of any other country. The Bank of Japan (BOJ), while supportive of the coordinated rate cut, did not participate. Not only are the ultra-low interest rates in Japan now less extra-ordinary because of the rate cuts elsewhere; more importantly, the BOJ has shown restraint and prudence in recent months. This may well be a reflection that boosting exports by weakening the yen may prove ineffective in a weakening global economy rather than the BOJ suddenly adopting a stoic attitude. However, we are sufficiently encouraged to elevate the Japanese yen to the family of hard currencies. We have argued for some time that the Japanese economy could absorb a stronger yen - with pain, but without crumbling.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com. Please also register for our free webinar on October 15, 2008, to get an update on our views on the economy and the markets.

Axel Merk
Axel Merk is Manager of the Merk Hard Currency Fund

The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risks - with the ease of investing in a mutual fund.

The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Funds shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fund's portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fund's prospectus. Foreside Fund Services, LLC, distributor.

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