We are seeing several of the large U.S banks return government funds received under the Treasury’s TARP program. This list includes Bank of America, Citigroup, JP Morgan, and now Wells Fargo.  In the context of the financial markets, these actions should be looked at from the macro level.  Looking at the grand scheme of things, this is nothing more than part of the unwinding of extraordinary stimulus measures.  Could this be considered part of the Fed’s exit strategy in cohesion with the Treasury? Why not?  It is evident that the Fed is trying to be very subtle; and it definitely does not want the market to consider a change of monetary policy.

If we continue to see more positive economic indicators such as the latest employment report and retail sales, then the signal would be that we could indeed be in the middle of a strong economic recovery.  That would definitely not be compatible with the Fed’s insistence on keeping rates exceptionally low for a long period of time.

With the news of banks returning government rescue funds, our minds should be saying “quantitative tightening.” In relation to currencies, this is dollar-positive.   The big question is, can the markets handle all the capital increases that the banks are realizing in order to make their repayments? Bank of America is said to be realizing the biggest capital increase on Wall Street since 2002.  The stock markets are being remarkable resistant to the capital increases. Truth to be told, I am amazed that they have been able to put off a correction for so long.  With the stock markets steady and the dollar rising, the high correlation between stocks and the currency is broken, at least temporarily.

We are in a period of a return to risk-aversion, yet stocks are performing well.  In the current scenario, it is easy to imagine the bears settle in, risk-aversion rise, and the stock markets fall.  However, if the economic indicators continue to show strength, uncertainty over the recovery could be put to rest and the above tendencies could change direction.

The European Central Bank has decided to cut its interest rate by 25bp to 1.25% instead of the 50bp rate cut expected. This has bullish implications for the euro and bearish implications for European stocks. As a matter of fact, we saw the EUR/USD spike higher after the rate decision and at one point tested the resistance at 1.35. European stock markets also gave back some of its previous gains, but not much.

It was clear that the ECB fell short of expectations. However, the story does not end there. As analysts know so well by know, the Trichet press conference that follows the decision could be as important or more important than the decision itself. And that was the case today.

While the decision itself fell short of expectations, the Trichet statements clearly made up for lost ground. Trichet stated that the decision was by consensus and not unanimous. By all likelihood, bigger rate cuts were debated among members of the monetary policy committee. No quantitative measures were expected and none were announced. However, Trichet makes up for it by clearly indicating that any decision to apply non-standard measures will be made in the next meeting. He also affirmed that further rate cuts could be applied.

These statements should please the markets or at least meet expectations. The ECB monetary policy will continue to be on the “easing” side although perhaps too gradually for some. Trichet did not hesitate to point out that the ECB has lowered rates by 300bp since October 2008. The change of policy did not start as early as in the U.S. and many now believe that the ECB is playing catch-up.

With one event risk out of the way, stocks resume the rally that was in place since early March. The Euro/Usd should maintain the price range of 1.30-1.35… for now.

As the week winds down, the markets could be faced with an overwhelming amount of data to digest.  This could lead to signficant volatility and sudden price swings.   However, there is not the same level of uncertainty as in recent months.  From this perspective and following the recent three-week stock market rally from the lows, there could be a bias towards the upside.  The level of uncertainty is not as high because we are starting see more concrete expectations for the following event risks.

Investors are looking for specific, coordinated measures to come out of the G-20 meeting.  However, investors are also aware that no major agreements are likely to come out of the meeting and that at most we could probably hope for some general framework.  Ideally, the markets want some decisions on new regulation of the financial markets.

The market is expecting for a 50 bp rate cut from the ECB.  This will likely happen as the Euro Zone is faced with serious economic problems.  But lot’s of attention will be on the Trichet statements.  Important announcements could be made and investors will be eager to know if the central bank will purchase private debt.  Again, this is not so much expectation as it is hope for additional catalysts.

Therefore, both the G-20 meeting and the ECB rate decision have potential to surprise to the positive side for stock markets. It is more likely for these events NOT to be short of expectations.  If they are, stocks could turn dramatically to the downside.

Same goes for the Employment Report as investors already have low expectations for employment figures.  However, if we use Wednesday’s ADP report as a leading indicator we could be in for a negative surprise.  The ADP report was much worse than expected in terms of job destruction.

As we could see, the second quarter is off to a busy start, not to mention that the earnings season will start next week.  Corporate earnings will probably be as important as ever (since the crisis started) for signals of any indication that a recovery is in the works.

It was not really my intention of compiling videos that explain the credit crisis.  However, I will occasionally come across a video that I believe does a good job of simplifying or pointing out the key elements of the current crisis.

I also noticed that my previous posts with such videos generate a good amount of traffic.  Thus, there is demand for this information as people are looking to understand the basis of the credit crisis or just want to further their knowledge of the situation.

I recently discovered the following video, which does a good job and can be found at www.crisisofcredit.com.  I embed the 11minute video below for your convenience.

These two other videos are also really good…

http://themarketanalyst.wordpress.com/2008/10/01/a-step-by-step-explanation-of-subprime-derivatives-as-seen-on-cnbc/

http://themarketanalyst.wordpress.com/2008/10/01/the-best-explanation-of-the-subprime-crisis/

In times of financial crisis, economists look for indicators that attempt to measure credit risk or as some call it, the “fear factor.”

Lately, many references are made to the TED Spread and this posts attempts to look deeper into this indicator.  Wikipedia defines the TED spread as the difference between the interest rates on interbank loans and short-term U.S. government debt (“T-bills”).

The TED spread is caculated as the difference between the 3month T-bill interest rate and the three month LIBOR.  The 3 month T-bill is considered to be practically risk-free since it is backed by the good faith of the U.S. government.  The LIBOR reflects the credit risks between commercial banks lending to each other.  Therefore, the difference could be considered a risk premium.

Historically, the TED spread was 0.3% on average.  This number increased during the credit crisis with a spike in September and then again to more than 4 in October 2008!  Large international banks were previously considered almost as risk-free as the U.S treasury, but now we see how banks have become fearful of lending to each other.

Long-term TED spread chart

Real-time TED spread

‘Ted Spread’ Reflects Rise in Global Anxiety

Similarly, the following blog post points out a spike in the difference between the overnight Libor rate and the fed funds target rate, the concept is the same: Econbrowser: Understanding the TED spread

Global stock markets are currently plummeting and it appears that the Wall Street open will not fair any better. We could see the stock market halted later today if down limits are hit. The futures already touched the limit low and the Wall Street open will be key. There could easily be authentic panic taking over and driving the markets to closure. N. Roubini has already predicted this would happen and he has just cited that the decline of the futures this morning is proof that stock markets will close.

Take a look at what the current limits are in this CNBC article, How Futures Numerical Trading Limits Work

The currency markets are showing huge deleveraging with the “carry trades” being massively unwinded.

This market move could also be related to another Roubini prediction, that 30% of hedge funds will enter bankruptcy. Could these stock market declines be massive liquidation by hedge funds?

Finally, the stock markets are operating in a more logical manner. However, volatility levels remain tremendously high and are still a very dangerous element.

It could be difficult to defend the idea that markets are operating in a logical manner with volatility levels at record highs. However, my basis for this statement is that the markets are finally reacting to fundamental economic and policy news. Central banks and governments appear to have finally gotten ahead of the curve. The markets are no longer discounting possible measures for the financial crisis before they happen, they are reacting on analysis of their effectiveness. The governments have finally stopped going after damaged entities in a singular fashion but have started implementing systematic solutions. An additional coordinated rate cut right now could have that “surprise” element that tends to help the markets in the short-term. As I suspected would happen after eight straight losing sessions and a sharp decline to the bottom of 7,800 on the Dow Jones, Monday, Oct. 13 was the first gain in October. It is likely that the bottom has been reached on Friday, Oct. 10, at least for the short-term. The bearish trend could easily resume to form new bottoms but it would be in a more orderly fashion and it would depend on the size of this recession and subsequent corporate earnings. This would be a much healthier way than the 10% daily declines that can cause panic and crashes. To be sure that we do not go back to those days, we first need to see volatility ease down.

The DJ and the S&P500 lost more than 1% for an eighth consecutive losing session in October.  So far this month, we have seen a -23% loss for the NY stock markets.  However, this eighth session was tremendously volatile.  The good news is that there were some tremendous rallies before closing very far above the intraday low.  <u>Therefore, I dare say that we could have found the bottom.</u>  Let’s keep our fingers crossed.  If we consider the intraday low, then the Dow Jones has seen a 29% loss so far this month.  That is almost one third loss of value!

Furthermore, that intraday low at the 7,800-8,000 level for the DJ coincides with a long-term bullish trendline.  It appears to have performed as a solid support level on Friday.  We could very possibly see a rebound here and the first winning session of the month on Monday.

Yesterday, the ban on short-selling was lifted.  Stocks fell another 7%.  Did the ban on short-selling do any good?  It doesn’t look like it, as stocks kept falling anyway. 

Once in place, the SEC should have extended the ban.  The problem was not short-selling but by constantly changing the rules they are making things worse.  This did nothing but add volatility to the stock markets. This action does not cease to amaze me; the market regulator is doing the opposite of what it’s supposed to be doing, which is to provide confidence to the markets.  Changing the rules on traders does not give them confidence.  It makes them constantly reverse long positions and reverse short positions.

Another thing that does not make sense to me is, why did they eliminate the up-tick rule last year? Bring it back!  The up-tick rule makes logical sense to me.  The up-tick rule means that if you want to short a stock you must first wait for an up-tick.  This makes sense and helps to prevent the manipulation that the SEC was so worried about.  With this rule, it means that you could only short if there is still buying pressure left, even if it is small.   In other words, Someone drove the price up before you shorted the stock. (otherwise, shorting has a domino-effect)

The biggest manipulator in the market right now is the SEC!

Read more about the uptick rule on Wikipedia, uptick rule

We are 7 for 7, Could we call this a crash yet…  We are most likely avoiding a crash by the skin of our teeth