Gain Capital

Just a week ago, financial markets looked to be further on the mend and it seemed as though the worst of the summer’s credit market crisis was past. Stocks were still on their highs, the USD was steadying on the back of reduced expectations of Fed rate cuts, and carry trades were making fresh highs after the July/Aug wipeout—all signs of markets normalizing and risk-taking behavior returning. But that was a week ago.

On Monday, a group of leading US banks announced plans to launch a fund designed to restore liquidity to off-balance sheet conduits (or SIV’s--structured investment vehicles) that remained locked out of the short-term lending markets. (These are the funds that borrow short-term, by issuing commercial paper, and invest in higher yielding long-term assets, which frequently included sub-prime and other mortgage backed debt. When the value of the long-term assets was called into question due to sub-prime concerns, these funds were unable to roll over the short-term debt and were forced to sell long-term assets at steep losses.) What was supposed to have instilled confidence in credit markets instead re-focused attention on the weakest segment and highlighted the corrosive assets remaining in those SIV’s. From then on, it was all downhill.
Along the way, disappointing 3Q earnings hit stock markets, which undermined riskier assets, such as carry trades, leading to a sharp sell-off in JPY-crosses. Weaker NAHB housing index and building permits/housing starts data further undermined the near-term US outlook, accelerating declines in stocks, the USD, and JPY-crosses. The icing on the cake was a downcast Beige Book that saw Fed Fund expectations reverse course and begin to price in (again) a ¼% follow-up rate cut from the fed on Oct. 31. As of Friday afternoon, Fed Funds futures are indicating a 92% chance of a ¼% cut, a complete 180 from indications on Monday of a 90% chance of a steady rate decision. Better than expected data from the UK (retail sales, 3Q GDP), higher inflation readings from Canada, and continued hawkish rhetoric from ECB officials then accentuated the weakness of the USD relative to others. Finally, Forex markets continue to expect no action from the G7 to stem USD declines/EUR gains, leaving little support for the greenback.

The outlook at the moment is for continued USD weakness, barring a surprise statement from the G7 or the US Treasury, which has until now allowed the USD to adjust gradually lower through benign neglect. The G7 communiqué is expected to be released around 1830EDT/2230GMT this evening, followed by a press conference by US Treasury Sec. Paulson. I’m expecting the FX portion of the statement to be virtually identical to the last G7 statement from June, with the Chinese Yuan to be the only currency cited as needing adjustment. The pace of the USD’s decline is the most important feature at this point, and while it remains gradual and orderly the US Treasury is unlikely to alter it benign neglect. If Treasury is to alter its stance, it will most likely use language indicating that the USD value is not properly reflecting US economic fundamentals. Another factor that seems likely to slow the USD’s descent is extreme short-dollar positioning, which surfaces as profit-taking buying of USD as new lows are made. In the short-term, continuing to sell USD on bounces appears the way to go.
The JPY-crosses, however, represent a vastly different trading outlook. The extremely high, positive short-term correlation of equity markets and JPY-crosses looks set to continue for the foreseeable future. The lack of G7 comment on the carry trades or JPY weakness would normally be a green light to buy the JPY-crosses, but the heightened downside volatility in equities throws a spanner into those works. While equities remain under pressure, there is little reason for the JPY-crosses to shift higher. We’re only a third of the way through 3Q earnings releases, so I expect more bad news from stocks before it’s all over. On top of that, expected weaker US housing data next week will only serve to highlight the dimming US outlook. If I had to pick a point in time when stocks might be expected to base out and turn higher, it would be just before or after the FOMC rate decision on Oct. 31, assuming they deliver a ¼% cut. Should stocks rebound unexpectedly, look for the JPY-crosses to shoot higher in dramatic fashion back toward their highs from late last week. Also, keep in mind the potential for the high, positive correlation between carry-trades (long JPY-crosses) and stocks to breakdown at any time, and G7 silence (= assent) may be a catalyst for that.

Oil continues to press higher, breaching $90/bbl briefly on Friday before retreating, and this is another source of equity market weakness and also contributes to USD weakness. Oil got a sharp boost this past week from geo-political tensions between Iraq and Turkey, which look to be a tempest in a teapot. Despite legislative approval to go after PKK guerillas inside Iraq, the Turkish government has instead requested Iraqi authorities to detain suspected terrorists, suggesting Turkey is not going to undertake a large scale operation soon. Despite these developments, oil continued to press higher on what now seems to be buying for the sake of buying, suggesting a speculative bubble has formed. A sharp set-back in oil prices represents another source for a potential recovery in US equities, and for a reversal of commodity currency strength, especially CAD. Also, note that 2008 global growth forecasts have recently been reduced, suggesting commodities may have over-extended to the upside.