Contagious Credit markets are giving the Fed a headache!

Blue chip financials no longer exist as they slowly drown in their own ‘sea of red’. Greed fueled by lax regulatory constraints continues to take its toll on the once impervious ‘financial entity’. The knock on effect should dominate the Fed’s thinking this afternoon.

The US$ is weaker in the O/N trading session. Currently it is lower against 9 of the 16 most actively traded currencies in another ‘volatile’ trading range.

Yesterdays US data played second fiddle to bankruptcies and heightened credit market losses. The ‘mother’ of all Chapter 11’s was filed by Lehman Brothers on the w/d, sending capital markets into a tail-spin. The bankruptcy announcement has created further turmoil in the credit markets and started a stampede amongst investors seeking safety and quality assets. Lehman’s demise threatens to unravel the $62trillion credit derivates market. The domino effect will be heard and felt by all financial institutions. This has led banks to hoard cash and send Fed Funds to a decade high above overnight (400bp over the Fed’s 2.00% funding rate). Futures traders have increased their bets (54% chance) that Bernanke will slash borrowing costs (2.00%) when policy makers meet this afternoon to offset financial market turmoil. Finding a suitor with deep pockets remains the prime objective for companies like AIG and Washington mutual.

Yesterday’s data showed that US factories continue to stumble. Total industrial production was down at a much sharper than expected pace in Aug. The -1.1% decline in output also comes on the heels of downward revisions to previous months. A decline in auto production accounted for almost the entire -1.0% drop in manufacturing production (as expected demand for cars slowed due to the run-up in gas prices over the summer). However, ex-autos, production fell by -0.3%. Other data showed that NY Empire survey headline declined (-7.4 from +2.8 m/m), posting the largest monthly pullback in 6-months. Its worth noting, that the prices paid sub-component fell (+44.8 vs. +65.2), most likely due to the significant retreat in oil prices of late (33% in 2-months). The employment component (-4.6 vs. -4.5) provides further evidence of continued layoffs in the sector.

The US$ currently is lower against the EUR +0.05%, CHF +0.79%, JPY +0.85% and higher against GBP -0.37%. The commodity currencies are weaker this morning, CAD –0.06% and AUD -2.39%. The loonie eased the most in 2-weeks yesterday, on the back of Lehman Brother filing chapter 11, heightening trader’s speculation that deepening financial losses may prolong the economic slowdown in the US. Canada has become guilty by its ‘proximity and association’ with its southern neighbor. The US remains Canada’s largest export market, over 75% of our exports head south and 50% of that is commodity based. With global growth issues a major concern, commodity prices continue to soften. This has led to a flight to less riskier assets and by default will continue to pressurize the loonie in the short term. Risk aversion trading remains the dominant theme as speculators continue to unwind the ‘carry trade’. For the time being, traders are happy in closing up shop until the latest fallout can be accurately accessed. With persistent softer data being reported south of the border, interest rate differentials are beginning to take a grip on the greenback’s value. The market will takes it cue from Bernanke and Co.’s communiqué this afternoon. Expect traders to be better buyers of US$ on pull backs as Canadian economic data remains soft. The currency has lost 6.0% of its value since oil’s registered its highs 2-months ago. Politically and economically Canada will be pre-occupied with its general election slated for Oct 14th over the next few weeks.

The AUD and NZD continue to trade under pressure, especially vs. the JPY, as investors are willing to aggressively unwind recent carry trades and enter into ‘risk aversion’ deals. Currency values are been driven by the equity markets, with a distressed market, natural reaction is to pare your riskiest assets. The high yielding assets of the Kiwi and AUD$ are considered a pair of the riskiest. Expect rallies to be sold for now (0.7878).

Crude is lower O/N ($93.34 down -337c). Both oil and gas prices collapsed yesterday and fell to a new 7-month low on the back of Lehman Brothers filing for bankruptcy and refineries along the Gulf of Mexico escaping major damage from Hurricane Ike. Capital markets are concerned about the fallout of other financial stocks and what their weakness will mean for the real economy and future energy demand. With the Gulf of Mexico successfully bypassing a direct hit from the storm over the w/d, production facilities will be expected to be back on line sooner than anticipated. Crude oil prices should remain under pressure as demand historically wanes when weather anomalies like Ike and Gustav occur. Analysts noted that Gulf operators had already evacuated personnel from 63% of production platforms. It’s estimated that 96% of Gulf oil production, and 73.1% of natural gas output, was shut in anticipation for the recent hurricanes. Lat week, OPEC President Khelil called on members to stop producing more than the group’s set quota, a move that would reduce supplies and perhaps provide some crude price support. Initial reaction has had the opposite effect, they had hoped to reduce a ‘huge oversupply’ of oil on the market, and at the same time psychologically provide an artificial floor for the black stuffs prices. Global growth concerns continue to trump what some OPEC members are trying to achieve. One should expect the Saudis to put a ‘spanner’ in OPEC’s thought process. Last weeks EIA report showed that fuel demand declined w/w and refinery production dropped. Operating rates fell to 78.3%, the lowest level in three years. Gold declined O/N ($778), the 1st day in three, as investors sold the ‘yellow metal’ to raise cash after global equities continue to trade heavy on increased speculation that credit- market losses and the economic slowdown will only worsen.

The Nikkei closed at 11,609 down -605. The DAX index in Europe was at 5,963 down -100; the FTSE (UK) currently is 5,106 down -98. The early call for the open of key US indices is lower. 10-year Treasury yields have eased 32bp from Friday’s close (3.38%) and are little changed O/N. Treasury prices have rallied especially in the front end of the US yield curve (1.86%-bull steepener) and managed to print monthly low yields as Lehman Brothers filed for bankruptcy and traders speculated that the Fed will have to cut interest rates (from 50-75bp) to shore up consumer confidence and provide support for the battered financial industry. The flight to quality remains steadfast as equities print red. OIS traders continue to price in a Fed rate cut by year end (2.00%), some optimists are even calling for an ease at today’s FOMC meeting.

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