Forex Market Update

Safe haven status of the greenback wearing thin for the USD as European majors stage a comeback. How far can correction go?
    

Market meltdown sparks historic gold rally that suggests lack of faith in all currencies. Market liquidity continues to deteriorate.



MAJOR HEADLINES – PREVIOUS SESSION

          o Australia Q3 Westpac ACCI Industrial Trends survey fell to 50.8 vs. 53.9 in Q2.
          o Japan Aug. Nationwide Department Store Sales fell -3.1% YoY vs. -2.5% in Jul.
          o Switzerland Aug. Trade Balance out at 1.43B vs. 1.03B expected


THEMES TO WATCH – UPCOMING SESSION

Key Risk Events (All times in GMT)

    * UK BOE's Dale to Speak (0800)
    * UK Aug. Retail Sales (0830)
    * Switzerland SNB to announce Target Rate (1200)
    * Canada Aug. Leading Indicators (1230)
    * US Weekly Initial Jobless Claims (1230)
    * US Sep. Philadelphia Fed (1400)
    * New Zealand Aug. Current Account Balance (2245)

Market Comments

After the dramatic fall of AIG and then new worries yesterday about the safety of even money market funds, some market participants are beginning to turn to the oldest of all safe havens in search of value: gold. Gold rose over 80 dollars yesterday, its largest rise ever. And apparently, as a Bloomberg article reports, this was not just a market phenomenon. Dealers in actual gold coins and bullion were reporting frantic activity yesterday, with people actually buying physical stock. With this kind of activity taking place, we simply have to be nearing the climax of the "crunch" phase of this crisis.

But how much longer can markets stand these conditions? No one wants to own anything but cash or short term government Treasuries. Banks are not lending and the markets are simply not functioning. The spread between 3-month Libor and the US 3-month T-bill has increased beyond the spike in the 1987 stock market crash to as much as 300 basis points. FX forwards are disorderly as well, to say the least.

The timing of all of this is truly remarkable for the US political scene as well. We are seeing an intense crunch slamming markets just a matter of weeks from a US election with the sitting president not even up for reelection. The US legislature will also go into recess in a matter of weeks. The rapidly unfolding events are being left to the Fed and the Treasury, but a bigger solution would require the Congress' approval. Is there time for anything but stop-gap measures?

The events unfolding are beginning to turn the tables in FX-land, as yesterday saw the USD weaken sharply rather than it finding strength on safe haven status. Many are undoubtedly concerned about how much more of the US economy may end up nationalized and therefore the credit-worthiness of the US national debt. Meanwhile, the yield on that debt is rapidly approaching zero at the short end. So this means that those who believe the UK and Europe won't sink into the ocean can get 4% or more on 3-month T-bills. On that note, GBP has performed very well lately, perhaps as the EUR is seen as overvalued in the bigger picture and as the market may simply be unwinding its very large short GBP positions to raise capital in this "cash is king" environment. It's tough to say, however, how much of what is going on is position unwinding versus putting on of new positions.

In response to some of the demand for short term government debt, but also to shore up expand the reserves available to the Fed for dealing with further market turmoil, the US Treasury announced an auction of $40 billion in short term T-bills today. These will disappear in a heartbeat and more of this kind of supply will likely need to come on line. The US can go on printing money endlessly in this way, we must remind ourselves, and it's debt load as a percentage of GDP is still far smaller than that of, for example, Germany, or especially Japan. Printing presses can run as long as the power stays on at Central Banks...

The SEC has also kicked into high gear over the last 24 hours - by first suspending all naked short selling as of today and now even announcing that it will be looking into all hedge funds' books for evidence of abusive short selling. These kinds of measures will undoubtedly increase, as one thing the authorities will not stand for is any further pressure on the systemic meltdown scenario. We can only imagine what kind of strict new regulations are on the way for banks and funds in the years to come. The tricky aspect of efforts like this is that they could trigger a kind of "artificial" rally that has the market questioning whether it is triggered by positive sentiment or shorts running for cover.

Clearly, something must happen soon - the world's financial authorities must step in soon in some kind of dramatic and coordinated way to ease this crisis. Some are suggesting the answer to all of this is the creation of a Resolution Trust Corporation style entity (used in the US Savings and Loan crisis) that takes over troubled assets of all stripes and unwinds them slowly in coming years, participating in any upside or downside as the market dictates. But this is an unbelievably complicated task - again, all coming as the US election is nearly upon us.

Whatever the solution to this panic, markets are not functioning and banks refuse to lend to one another. As long as things remain "stuck", the fear level and volatility can go anywhere - it doesn't appear that the market can sort this out by itself. Once we do see coordinated action, we are likely to get an enormous relief rally before we get back to the somewhat more boring task of watching to the real economy continue to weaken on the downside of this economic cycle. In the meantime, be very careful out there....liquidity is terrible - meaning wide spreads and erratic moves.

Chart: EURUSD
How high will it go? With the recent change of sentiment apparent in EURUSD, we are beginning to see a sizeable countertrend rally. Levels in focus if this move continues may include the previous low around 1.4570 and then the 0.382 Fibo retracement at 1.4700. The 55-day average is still way up above 1.5000. Clearly, there's lots of room for movement without breaking the overall bearish trend.

 

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