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FOMC on tap after one of Wall Street's worst days in history

Tue, Sep 16 2008, 06:55 GMT
by John Hardy

Saxo Bank

ECB and BoE hopelessly behind the curve - will they begin to send the right signals soon as inflation likely to move to 0?

MAJOR HEADLINES – PREVIOUS SESSION

• New Zealand Aug. Non-resident Bond Holdings out at 73.5% vs. 77.6% exp.

• Japan Aug. Tokyo Condominium Sales fell -38.8% YoY vs. -44.5% in Jul

• Japan Aug. Consumer Confidence fell to 30.5 vs. 31.6 in Jul.

THEMES TO WATCH – UPCOMING SESSION

Key Risk Events (All times in GMT)

• Switzerland Q2 Industrial Production (0715)

• UK Aug. CPI and RPI (0830)

• UK DCLG House Prices (0830)

• Germany Sep. ZEW Survey (0900)

• EuroZone Aug. CPI (0900)

• Canada Jul. Manufacturing Shipments (1230)

• US Aug. CPI (1230)

• US Jul. TIC Flows (1300)

• Switzerland SNB's Hildebrand to speak (1500)

• US Sep. NAHB Housing Market Index (1700)

• US Treasury's Paulson to Speak on Economy and Housing (1730)

• US FOMC Rate Decision (1815)

• US Weekly ABC Consumer Confidence (2100)

• Australia Jul. Westpac Leading Index (0030)

• Japan BoJ Target Rate (no time given)

• Australia RBA's Stevens to speak (0320)

Market Comments

As financial markets shifted into outright meltdown mode, the old risk appetite axis held fairly well yesterday in currency-land, with the lowest yielders JPY and CHF performing the best, and the likes of AUD and NZD suffering the most among the G10. The Scandies were also under pressure on collateral damage and EM currencies continue to struggle for support as well.

It's self-evident that today will be a volatile day with the Fed on tap this evening after the weekend's dramatic events. Many are talking up the potential of a 100-bp cut to the Fed funds as this renewed intense liquidity crisis falls over us. Our view is that the Fed may only go 50 bps, if only to leave a few more bps left with which to work further out. Could Fed funds eventually go to 0.50%? As long as financial stability is an open question as we undergo this greatest of financial crises since the Great Depression, the answer is likely in the affirmative.

The most pressing story at the moment following the Lehman debacle is AIG, the huge US insurer that is embroiled in its own liquidity crisis and which has now had its debt downgraded, making it even more difficult for the company to raise funds to shore up its capital reserves. The black hole of liquidity pressures is becoming a self-reinforcing and very scary phenomenon - can the whole insurance industry become the next focus? Let's hope that the market and the powers that be can short circuit this negative liquidity spiral sooner rather than later...

At this point, the ECB and BoE look downright absurd as they charge down the rocky financial path with their eyes firmly locked on inflation in the rearview mirror. We said some months back that Trichet's strong stance on inflation and keeping monetary conditions tight would either make the ECB look visionary or myopic. With the latest developments in financial markets, the latter is increasingly looking like the case and we wonder how long these central banks can continue to cling to inflation ghosts and when they will begin to give the sign that they are ready to administer the necessary monetary medicine to come to the aid of their dying patient.

So how will the market react to any Fed move this evening? This is tough to guess at the moment as we are all participating in a new and nerve-wracking experiment launched over the weekend: the US government decided to let Lehman fall into Chapter 11 as it felt that enough risk had been socialized with the Bear Stearns bailout and especially Fannie/Freddie takeover. Counterparty risk fears are now sweeping through financial markets globally as everyone looks around to see who could be next. With the decision to let Lehman go, Paulson and company are hoping that the financial industry will get the message that it must do some of the heavy lifting itself rather than automatically assuming that the Fed/US government backstop is there to socialize every single risk and put it on the taxpayer's balance sheet. Let's all hope the experiment succeeds. These are "interesting" times to say the least...

At present, the market can't seem to decide whether to sell the USD on the desperation evident in the US financial sector, or to buy it due to global deleveraging and repatriation of the flows from the emerging markets which suddenly don't look as promising as they did just a couple of months ago. Short term (and very large) volatility potential aside, the deleveraging theme is the most likely one to win out in the end and continue to support the USD. In any case, beware of volatility as we are hearing of extreme liquidity problems in the market.

Chart: EURCHF

As we write above, volatility is guaranteed today with markets in white knuckle mode ahead of the FOMC decision. EURCHF has moved surprisingly little considering the high readings we're getting on the Richter scale of risk. The downside should continue to be the side of least resistance as long as global yields are falling and equities remain under pressure.

Published on  Tue, Sep 16 2008, 07:01 GMT