This morning’s dismal news in the financial sector is stealing the news headlines, along with Hurricane Ike--certainly been watched by energy traders. Both the stock index and crude oil futures markets are tumbling in early trade, and the question is, where is the bottom? The environment is not for the risk-averse. It’s going to be choppy and sloppy. The markets have been unwinding risk and if you aren’t well-capitalized--be careful.

The markets’ reactions were relatively tame to the Treasury’s arranged takeover of Fannie Mae and Freddie Mac last week, which helped to sooth the credit markets and stock market. Treasury yields had moved mainly sideways, but his morning, the flight-to-quality kicked in on the Lehman bankruptcy news, sending the 30-year bond futures and 10-year note futures up more than a point.

Recent economic data had already been showing more signs of slowing in third quarter growth – with weakness showing up in a range of indicators, including retail sales and imports. And inventories are pointing to future weakness. However, lower gasoline and crude oil prices helped the latest inflation numbers come down.

Stock Market
The stock market fared quite well last week considering that it could have been a nightmare had Fannie Mae and Freddie Mac not been “rescued.” Last week, the Treasury and other regulators announced the placing of Fannie Mae and Freddie Mac into conservatorships. Stocks generally rallied in response, as the move was seen as soothing the credit markets and even lowering mortgage rates. The takeover plan included the Treasury buying over time a sizeable portion of Fannie and Freddie’s mortgage backed securities. This was seen as liquefying the mortgage market. The net effect of the takeover – among others – included the likely speeding up the housing recovery (albeit still slow). And stocks liked that implication.

But as more troubles unfold in the financial sector, the tide has turned and a bailout for Lehman was not in the cards. News that Lehman Brothers Holdings filed for bankruptcy after failed rescue talks over the weekend dominated headlines this morning. Merrill Lynch (also a victim of the ongoing credit crisis, agreed to be bought out by Bank of America. We still don’t know the extent of continued fall-out from the credit crisis of 2007, and more trouble could be brewing. American International Group is reported to be seeking bridge loans from the Federal Reserve, and speculation about further targets in the financial sector is hitting stocks across the board.

The biggest question is whether the Fed will still be anticipating an expected moderate slowing in growth, rather than an outright recession. Federal Reserve policymakers meet for their regularly scheduled policy meeting on Tuesday, September 16, and now market participants are anticipating the Fed will lower its key short-term lending rate (known as the Federal funds rate) from 2 percent.

The S&P 500 futures opened sharply lower on the news this morning, and are trying to rebound off the lows. July’s low comes in as support near 1201, and, we’ll see if that can hold. If not, the bears will be fully in charge. Key support is in the 1196-1199 zone for the December contract.

Crude Oil

Crude oil prices have now tumbled to a seven-month low, despite Hurricane Ike squarely aiming at Texas’ oil refineries and an OPEC announcement cutting production quotas last week. Hurricane Ike didn’t damage key refineries as much as feared, and participants sold crude oil on the news. Traders are now focusing more on demand than on supply, and demand clearly is slowing.  Demand is becoming an issue for all commodities.

Economies overseas are experiencing slower growth, with a few countries likely already in mild recession. In the U.S., demand also is slowing, as indicated by the August retail sales report released last week. Traders are especially focusing on this softness after the International Energy Agency this past Wednesday lowered its forecast for global oil demand in 2008 and 2009.  Crude oil futures are now trading under $95 a barrel amid the meltdown in the financial sector this morning.

Foreign Exchange

The euro currency broke to $1.39 on Wednesday, September 10, but has regained some traction as the dollar fell from a one-year high last week. The dollar’s summer rally has faded as traders increased their bets that the Federal Reserve would cut interest rates again by the end of the year because of the weak economic data last week, and now the Lehman meltdown. Rate cuts from the Fed are likely to be dollar-bearish.

The December Dollar Index futures were trading at 79.39. From a technical standpoint, the 10-day moving average comes in at 79.49, while the 20-day is at 78.50. Momentum indicators, the Stochastics and Relative Strength Index (RSI) are turning bearish. Look for support at 77.50 and 74.75.

While European Central Bankers have been steadfastly focused on inflation, participants are wondering whether Europe would be forced to cut interest rates, given the global spread of the economic malaise. The dollar had gained almost 13 percent since touching the all-time low on July 15 as the European economy slumped and crude oil dropped more than 30 percent from its peak.

The euro rose against the dollar last week after Luxembourg Finance Minister Jean-Claude Juncker was reappointed to represent Eurozone finance ministers and said he doesn’t expect a prolonged recession. European Central Bank Vice President Lucas Papademos said that the economy is likely to escape a recession. Despite the machinations, the euro ended the week slightly below last week’s close. We’ll see what rhetoric is yet to come across the pond given the latest financial meltdown.

Risk aversion was evident in the currency markets in general. The yen benefited from a continued unwinding of carry trades, in which investors sell low-yielding instruments (such as Japan’s), to fund purchases of riskier, high-yielding assets. Japan’s economic fundamentals have not changed. A recession is expected and there is little prospect that the Bank of Japan will increase its policy interest rate, which currently stands at 0.5 percent. The yen had played the low-yielding part in carry trades. Carry trade investors sold the yen heavily to fund the purchase of higher-yielding assets elsewhere. Now those positions are being reversed as investments are liquidated across a range of asset classes and regions across the globe including commodities.

Financial Fundamental Reports:  Week of Sept 15 – Sept 19, 2008

 Please feel free to call me at 866-231-7811 or contact me via email at jfriedman@lind-waldock.com if you have questions on this topic or to discuss specific trading strategies for your unique situation in this or other markets.

Good luck and good trading!

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