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Finally it seems to be sinking in that a lot of this trouble is US centric and the Dollar is falling. Will this become an issue for Paulson and Bernanke and should we expect the rhetoric to start again? Probably yes but I am somewhat surprised they have been so quiet but it looks as if they knew what was coming and tried to get the Dollar up before it hit. Regular readers will remember I suggested they had spent a lot of time visiting financial institutions recently and I suggested they had been worried with what theyfound. Intervention is not an issue here as the turmoil is bad enough in equities and bonds let alone creating more in FX. Therefore I expect to see further weakness in the Dollar and as expected we are now seeing it fall against the JPY and CHF. EURCHF in my view is still too high for the crisis we face. EUR is set to take out the highs and maybe today if we can get through the build up of gamma towards 1.60 and stops are big just above.

The headlines regarding Fred and Co are hiding the major problem and that is the 2nd tier banks that won’t get bailed out. Shareholders have every right to be worried and these institutions had a bad session yesterday and I suggest more notice should be taken on Thursday’s releases of the 2nd tier banks rather than JP Morgan and ML. I have often warned that this is the real danger and next we shall see the pick up in corporate delinquencies. This credit issue cannot fail to hit main-street and anyone who tells you otherwise is blind. If not handled well, and I cannot see how they manage this, the US economy will find itself deep in recession and any notion of it being V shaped are over optimistic.

The other casualty in this accident has the UK sitting in the passenger set and cannot escape this carnage as the UK economy rests on financials, property and a strong consumer. Even with massive discounts the UK consumer is pulling in the spending and this is set to continue and I still see a retail sales shock very soon. GBP will continue to under perform and selling against CHF and JPY should prove profitable. Gold is breaking out and should take out the highs very soon and oil just refuses to give up this march towards $150 and above. The timing of this, coupled with the credit issue is a nightmare for central banks and some will make a mistake. Possibly Trichet already has as he seems blinded by one needle in his compass and the cracks are getting bigger as even manufacturing falters in Germany. This is a real problem in the long run and I will monitor it closely but for now I remain bullish on the EUR but the turn is less distant than some may assume as in my book the Euro zone needed a rate hike like a hole in the head.

In the US today we get retail sales data and the market looks for +.4 but there is a real danger it maybe less than that and we should not ignore the PPI data either as the Fed certainly will not. BB speaks again and so liquidity could be light in this session.

By now you have all read and digested the news about the GSE’s and the discussion now turns to whether this is enough to restore confidence in the industry as a whole and the broader financial sector. As an investor I think I would be pleased that the government is prepared to ‘lend’ more money and bail out the business but I would use the subsequent rally to get the hell out as the statement suggested the money would become available ‘if and when they need it’. It sounds to me that this means when the equity value falls a lot further and a real crisis is seen. Not for me thanks. This is not an equity bail out and the risks remain to shareholders and I see a 16% rally off such a low price as quite dreadful.

The rally in the Dollar overnight in Asia looks like a profit take but I do not see the rally lasting long from here and the all time high is still in danger on the EUR. Problems remain in other areas of the financial sector and with Citi and ML reporting later this week and with nervousness surrounding Lehman’s, there are still many possibilities for further shocks. A regional bank in the US saw a run on deposits and INDY Mac has been taken over by the FDIC and shareholders have lost everything. Regular readers will remember I have been suggesting that regional banking failures will hit in the summer and we are seeing the start of this now. Confidence in the sector has further to fall along with equities generally and whilst the Fed is doing as much as possible, it cannot and will not bail everyone out and a larger institution could easily be let go. Maybe not Lehman’s as the connectivity with other banks could cause counter-party risk or failure and this is the systemic risk that worries the Fed the most. You know when things are bad when the SEC issues a warning on rumours! Try policing that!

An article in the Times today suggested this is jut a financial crisis and not an economic one but this is total nonsense as many companies are based on leverage and debt, which have grown with the availability of cheap and accessible funding but those days are over so we can expect more corporate delinquencies to come across a broad section of businesses. UK banking shares are off the base as Alliance and Leicester are reported to be taken over, possibly by Santander and talks are said to be at an advanced stage. An interesting buy at this stage and they have so far been diverse enough not to be hit by the housing issues here or in Spain.

I note with interest, comments from MPC member Barker as she suggests the decision not to cut rates in the UK is a tough one and feels the Board should avoid interest rate overkill in fight against inflation and send the economy into a tailspin. SStg was unimpressed but I suggest that the decision to hold was close and any chance of a hike is totally for those away with the fairies. GBP is still in danger and again I suggest that EURGBP will be a lot higher soon. The Dollar will prove an opportunity on this rally as I see a quick test to the recent highs set over 1.60. I still don’t understand the strength in EURCHF and am a constant seller on these rallies.

The Asian session saw little action in the FX arena after a quite dreadful close on Wall St. Bonds have seen a great deal of volatility as equities dive into bear markets but the FX market is strangely subdued as even risk aversion trades fail to materialize.

So what is going on and why is there so little concern over the Dollar as other assets tumble? It appears there are some very large sellers of volatility out there and some suggest Asian central banks are on both sides of the recent tight EUR range and on the bid of USDJPY. It is quite disturbing that FX players are so reluctant to take on these levels as some major issues are at stake for the US as the economy gets buffeted and financial institutions continue to show how fragile their business models really are.

Without doubt the Dollar should be lower as some of the issues, such as Freddie and Fannie are US centric and the continuing slide in the housing market is set to create a lot more problems for BB and the boys at the Fed to deal with. Yes, there is an argument on the terms of trade negativity in the case of Japan that could keep the JPY weak for a while but if the Dow close we saw last night happened two months ago, we would have walked into a USDJPY level nearer 103 than 107.00, it just has not moved! There is an issue here and it is one that needs careful consideration, as the last thing the US and many others, especially in the Gulf and other areas that have their currencies pegged, is a Dollar collapse. There looks to be evidence that when BOK intervene, they might be buying the Dollars back through EUR and JPY which is the frustration for those short GBPJPY.

In these modern times I do not expect to see clear and definable coordinated intervention from central banks, I expect it to be covert and timely with any agreements kept behind closed doors and I remind you again that Paulson and Bush have both been to the Middle
East recently and I firmly believe a deal was struck. I am not sure yet but this crushing of volatility in FX could be the start of something so I shall continue to dig but for sure something is not right here.

Elsewhere the AUD got a lift from some better than expected labor data and a comment or two from the IMF stating that with commodities expected to stay high for longer, the AUD inflation surge would remain and suggested the RBA continue to raise rates. This is becoming a tough decision for the RBA and one that could force the consumer over the edge as in the UK. This rally is quite strong and has some momentum but the headline numbers hid some worrying back revisions lower and it is the domestic erosion in the basic economy which worries me going forward and I believe a lot of this inflation is lagging. Therefore, as in the UK, it would be a huge mistake to hike again.

As I have said, timing the fall in the AUD is tough so look to use the low vols to put on some downside through options. The MPC has the same issue and analysts still suggest in some cases that they should hike! This is crazy and in fact in my opinion they should cut today but are unlikely to do so but I would have a small risk reward trade on it just in case they wake up and look at what is happening. The consumer shock is on its way with unemployment is rising and this will keep wage demand steady. I still feel EURGBP is a buy on any dip and GBP will continue to under perform and I note whilst writing the dismal Halifax housing data for June. Ouch! This economy is in big trouble Merv so cut today guys.

I still feel we should be getting short EURCHF as this turmoil is set to intensify and earnings in the US look set to be gloomy and keep an eye on dividend withdrawals or reductions. These equity markets are nowhere near a buy on the dip so stay away.

Asia was enjoying a rather quiet session but news that Iran had tested some nuclear missiles sent investors back into oil and sellers of Dollars. Whilst the move has been somewhat muted it has taken the shine off the stronger close on the Dow last night. As London traders assess the damage it appears that most are still happy to be Dollar buyers as long as oil doesn’t jump from here. At present crude is trading just a buck higher at 137.10 but some of the Asian bourses had a soft close. This action from Iran will bring strong condemnation from the US and others so it is hard to justify the thought that geopolitical tensions have passed here especially as this action comes hot on the heels of the statement that they were prepared to look into holding dialogue on the subject. Iran seems determined to flex its muscles here and this could put a floor under oil prices for a day or so.

The FX arena is actually rather boring in the majors as tight ranges persist and is dominated by short-term trading and central banks either side of the ranges. Elsewhere though the action is a little hotter as the KRW bounces aggressively after intervention. I actually like being short AUDKRW for a while. Swedish industrial production is stalling and was the 6th consecutive month of decline and has sent EURSEK higher and a trend could be developing here even though two further hikes are priced in.

Elsewhere Bernanke rides to the rescue again and leaves the Feds ATM open all hours for Investment banks to dip into. This has seen the pressure off equities but this will not last as the cancer has spread from the financials to a broader market. Oil and commodities hold the key still and the G8 guys must reali\e that the ETF indexes are a major part of the problem as in some cases the index is bigger than the underlying. The fact that pension funds can diversify about 5% of their portfolio in to commodity indexes is a major problem because it is a ‘not for profit’ trade. It is a diversification of portfolio and so I don’t see these guys rushing to the exit in a hurry. The amounts involved are huge and I am not even sure they have all allotted their quota yet! If the guys at G8 want to turn commodities around then some serious restriction on ETF’s is the only way and I am not sure there is the political will to force a change here.

AUD data continues to worry me and I feel a lot of the terms of trade positives are fully priced and the domestic erosion of the economy will force itself to the front of thinking for investors and a decent fall should be seen over time and follow the Kiwi, GBP and Dollar down. Aussie Home loans approvals for May contracted by the most in nearly 8 yrs at -7.9% (mkt:-2.0%). April’s read was revised down to -4.2% from -3.0%. Investment lending printed on the weaker side, falling 6.8% after having risen by 0.7% in April. April’s reading was revised down to 0.7% from 1.4%. The value of home loans also fell by 5.7% in May. Australia’s Westpac consumer confidence index comes in at -6.7% for July versus -5.6% in June. This month’s reading marks a 2nd consecutive month of negative readings shortly after the index briefly dived into positive territory in May. The index dropped to its lowest since 1992 at 79pts.

As I have mentioned before the economic situation in Australia in becoming increasingly similar to that in New Zealand. In the latest RBA statement the contraction of household spending and credit to businesses has taken the spotlight off the risks to inflation as a major worry, and this should sound as an alarm bell to the holders of AUD on a structural basis. The fact that the use of credit in Australia is very high (one of the highest credit to GDP ratio among G-10 economies) can cause heavy damage as liquidity dries up on a global basis. Moreover the AUD is the only currency with a large C/A deficit that has not dropped yet in the G-10 space. For now we can say that the AUD has held well because of market expectations that the RBA could hike rates to contain inflation expectations, but the market is already scaling back this possibility, with the rates curve currently flat with an upward bias and I feel they are on hold from here.

Not a great deal in FX overnight but the dollar is under pressure as Europe opens to an equity tumble. Most European equities are about 2% lower at this time and lead by banking and builders stocks. UBS is down about 4% with the builder Persimmon down 34% as they are due to announce figures today. This is keeping the Dollar on the back foot and there is increasing concern for the US equity opening as fears of a FASB rule change could cause Fannie and Freddie to have to raise billions in new capital.

This could be the start of the next leg down in financials and the S&P officially became a bear market yesterday as it has dropped 20% from its highs. The contamination in the banking industry is far from cured as no transparency exists and so they will not lend to each other. We need to get to a state where they are forced to value this toxic waste and move on. The trouble is many will be sent to the wall and even the regulators fear this. For this reason the problem will continue and credit will remain very tight. This will impact businesses across a broad spectrum and especially all of those running on leverage or debt.

Equities do not stand a chance in this environment and have further to drop. The fact that markets are pricing in rate hikes the US and UK seems to me to be total madness or at least a great opportunity. There is a real danger that this equity drop sends a major institution close to failure in the banking world but the chance of a second tier or Landesbank going under is very large.

UK data continues to threaten and I fully expect a consumer revolt and a shock in the data soon as the man in the street is now aware that he cannot afford his energy and grocery bills any more. The MPC should cut rates this week but probably will wait. This potential hike that is priced should disappear very very soon. GBP will remain a target and EURGBP is still a bargain down here on a multi-week basis.

US pending home sales will be closely monitored again today after a jump in April as the housing market continues to weigh on the hearts and minds of the US investor and consumer communities. The Dollar should slide again in this scenario and the rally of yesterday held well at the important support on the EUR at 1.5605. We now have a defined range of 1.5605-1.5935. I expect these to hold for now as we get to hear both BB and Paulson talking this afternoon on regulation and lending criteria.

AUD and Kiwi are beginning to suffer a little and I remain bearish on both. The June business conditions survey, which printed at a 7-year low also placed some downside pressure on the AUD. AUD/JPY was pulled lower, but the AUD fared well on the cross rates. However there are substantial cracks appearing in the domestic data and although AUD is widely expected to do well because of its terms of trade advantage, there is a real danger of a shift in rate expectations soon.

With vols where they are, it is a safer trade in options although I seem to be in a minority of one at present with this view. June jobs data could be the straw that breaks the camels back. New Zealand business confidence held at a 33-year low of -64% in Q2 as firms’ own outlook deteriorated, adding to evidence the economy was in recession in H1 of 2008. The NZIER said a net 64% of firms saw general business conditions to worsen in the next 6 months, unchanged from Q1, which was the worst reading since Dec 1974. We have not seen the big move lower in Kiwi yet but it should be played against a basket and not just the Dollar.